The tax treatment depends on whether your annuity money came from pre-tax or after-tax dollars

An annuity's tax bill splits into two parts: the money you put in (your basis) and the earnings that money made. The IRS taxes only the earnings portion when you withdraw it. How much you owe depends on what kind of account held the annuity before you bought it, and whether you've started taking payments yet.

If you bought the annuity inside a traditional IRA or 401(k), every dollar you withdraw is taxed as ordinary income, because you never paid income tax on the money going in. If you bought it with after-tax money outside a retirement account, you pay tax only on the growth, not on your original investment. The timing of withdrawals also matters: money you take before age 59½ may trigger a 10 percent penalty on top of income tax.

Key Takeaways

  • Annuities inside IRAs and 401(k)s are fully taxable when withdrawn because the contributions were pre-tax; annuities bought with after-tax money are taxed only on the earnings portion.
  • Withdrawals before age 59½ from retirement-account annuities usually face a 10 percent early withdrawal penalty plus ordinary income tax.
  • Once you start receiving annuity payments, the IRS uses an exclusion ratio to determine what portion of each payment is tax-free return of your basis and what portion is taxable earnings.
  • may have access to annuities (those inside retirement plans) and non-may have access to annuities (those outside retirement plans) follow different tax rules and use different IRS worksheets.
  • If you surrender an annuity before annuitization, you owe tax on all gains, and the 10 percent penalty applies to gains only if you are under 59½.

Annuities inside retirement accounts: everything is taxable

When you buy an annuity inside a traditional IRA, SEP-IRA, straightforward IRA, or 401(k), the entire withdrawal is treated as ordinary income. You do not separate basis from earnings because the IRS already knows you got a tax deduction for the money when it went in.

The IRS calls these may have access to annuities. The word "may have access to" means the annuity sits in a may have access to retirement plan, not that you passed some test. When you start taking payments, every dollar counts as taxable income. If you withdraw a lump sum before you turn 59½, you owe income tax on the full amount plus a 10 percent penalty.

The only exception is if you roll the annuity into another IRA or 401(k) without taking possession of the money. That move is tax-free and does not trigger the penalty.

Annuities bought with after-tax money: only earnings are taxed

When you buy an annuity outside a retirement account—with money you already paid income tax on—the IRS taxes only the growth. Your original investment, called your basis, comes back to you tax-free.

The IRS calls these non-may have access to annuities. To figure out how much of each payment is taxable, the IRS uses an exclusion ratio. This is a fraction: your basis divided by the total amount you expect to receive over the life of the annuity. If your basis is $100,000 and you expect to receive $200,000 total, your exclusion ratio is 50 percent. That means 50 percent of each payment is tax-free and 50 percent is taxable.

The IRS publishes life expectancy tables based on your age when payments start. You use your age and the annuity's payout structure to find how many years the IRS expects you to collect. Multiply that by your annual payment to get the total expected amount.

How the exclusion ratio works in practice

Say you are 65 years old and buy a non-may have access to annuity for $150,000. It will pay you $12,000 per year for life. According to IRS life expectancy tables for a 65-year-old, you have 20.0 years of life expectancy remaining. So the IRS expects you to receive $12,000 × 20 = $240,000 total.

Your exclusion ratio is $150,000 ÷ $240,000 = 0.625, or 62.5 percent. Of each $12,000 payment, $7,500 is tax-free return of your basis, and $4,500 is taxable earnings. You report the $4,500 as ordinary income on your tax return.

Once you have recovered your full basis—after 12.5 years in this example—every payment becomes fully taxable. The IRS does not let you recover basis faster than the life expectancy table says you should.

Withdrawals before age 59½: the 10 percent penalty

If you withdraw money from an annuity before you turn 59½, the IRS usually adds a 10 percent penalty on top of income tax. The rules differ depending on whether the annuity is may have access to or non-may have access to.

For a may have access to annuity inside a 401(k) or IRA, the 10 percent penalty applies to the entire withdrawal amount. If you withdraw $50,000 before 59½, you owe income tax on the full $50,000 plus a $5,000 penalty.

For a non-may have access to annuity, the 10 percent penalty applies only to the earnings portion, not to your basis. If you withdraw $50,000 and $30,000 of that is basis and $20,000 is earnings, you owe income tax on the $20,000 plus a $2,000 penalty (10 percent of earnings only).

Some exceptions exist: you can avoid the penalty if you are disabled, if you withdraw for medical expenses above 7.5 percent of your adjusted gross income, or if you set up a series of substantially equal periodic payments under IRS Rule 72(t). These exceptions are narrow and require careful calculation.

Annuity payouts and the tax forms you receive

When an insurance company pays you from an annuity, they send you a Form 1099-R each year. This form shows the gross payment, how much is taxable, and whether a 10 percent penalty applies. The company calculates the taxable portion based on the exclusion ratio (for non-may have access to annuities) or reports the full amount as taxable (for may have access to annuities).

You report the taxable portion on your Form 1040 as ordinary income. If the company withheld federal income tax from your payments, that withholding appears on the 1099-R and reduces what you owe when you file. If you did not have enough withheld, you may owe tax when you file or face an underpayment penalty.

The 1099-R also shows whether a 10 percent penalty applies using a code in Box 7. If the code shows a penalty applies and you believe you may have access to for an exception, you report the exception on Form 5329 when you file your return.

Surrendering an annuity before you start payments

If you cash in an annuity before you begin receiving regular payments, you owe tax on all the gains (earnings minus any fees or losses). You do not use the exclusion ratio because you are not annuitizing—you are straightforward closing the account.

For a non-may have access to annuity, you owe income tax on the earnings only. For a may have access to annuity, you owe income tax on the entire withdrawal. If you are under 59½, the 10 percent penalty applies to the earnings (non-may have access to) or the full amount (may have access to).

Some annuities have surrender charges if you withdraw money in the first 5 to 10 years. These charges are not tax-deductible; they reduce the amount you receive but do not change the taxable gain. If you surrender a $100,000 annuity that is now worth $110,000 and pay a $5,000 surrender charge, you receive $105,000 and owe tax on the $10,000 gain.

State income tax on annuities

Most states tax annuity income the same way the federal government does. If your state has an income tax, you will owe state tax on the taxable portion of your annuity payments or withdrawals at your state's ordinary income rate.

A few states—including Illinois, Mississippi, and Pennsylvania—offer partial or full exemptions from state income tax on annuity income, but the rules vary and change. Check your state's tax agency website or a tax professional in your state to learn whether you may have access to for any exemption.

Frequently Asked Questions

Do I owe tax on annuity gains while the money is still in the annuity?

No. As long as the money stays inside the annuity contract, you owe no tax on the growth, even if the annuity earns interest or investment returns. Tax is due only when you withdraw money or start receiving payments. This tax deferral is one reason people buy annuities.

What happens to my annuity if I die before I recover my basis?

If you die before you have received back your full original investment, your beneficiary may be able to deduct the unrecovered basis on their income tax return. The rules are complex and depend on the annuity type and how it is structured. Your beneficiary should consult a tax professional.

Can I avoid the 10 percent penalty by rolling my annuity into an IRA?

Yes, if the annuity is inside a 401(k) or other employer plan. A direct rollover to a traditional IRA avoids the penalty and income tax. If the annuity is already in an IRA or is non-may have access to, a rollover does not help because the penalty rules do not change based on where the money sits.

How do I report annuity income on my tax return?

You report the taxable portion on your Form 1040 as ordinary income. The insurance company sends you a Form 1099-R showing the taxable amount. If you received a 1099-R, attach it to your return. If the company made a mistake on the 1099-R, contact them to request a corrected form before you file.

Does the exclusion ratio change each year?

No. Once you start receiving annuity payments, the exclusion ratio stays the same for the life of the annuity. The IRS calculates it once based on your age and life expectancy at the time payments begin. If you live longer than the IRS life expectancy table predicted, all payments after you recover your basis become fully taxable.