The tax treatment of non-may have access to annuities

A non-may have access to annuity is one you funded with after-tax dollars — money you already paid income tax on. When you withdraw from it, the IRS taxes only the earnings portion, not your original contribution. Your contribution comes out tax-free because you paid tax on it when you earned it. The earnings portion is taxed as ordinary income at your regular tax rate.

This is different from a may have access to annuity (like one inside a 401(k) or IRA), where the entire withdrawal is taxed because you got a tax deduction when you put the money in. With a non-may have access to annuity, you are essentially getting taxed twice on the earnings — once when you earn the money, and again when you withdraw the growth.

Key Takeaways

  • Withdrawals from non-may have access to annuities are taxed using the exclusion ratio method, which separates your contribution (tax-free) from your earnings (taxable).
  • Earnings are taxed as ordinary income at your regular federal tax rate, plus any applicable state income tax.
  • If you withdraw before age 59½, you may owe a 10 percent early withdrawal penalty on the earnings portion only, not on your contribution.
  • The order of withdrawal matters: earnings come out first under IRS rules, so early withdrawals hit the taxable portion before your contribution.

How the exclusion ratio works

The IRS uses a formula called the exclusion ratio to determine what portion of each withdrawal is tax-free and what portion is taxable. The formula divides your total contribution (called your "basis") by the total value of the annuity at the time you start withdrawals. That percentage stays the same for the life of the annuity.

For example, if you put $100,000 into a non-may have access to annuity and it grows to $150,000, your basis is $100,000 and the total value is $150,000. Your exclusion ratio is 67 percent ($100,000 ÷ $150,000). That means 67 percent of every withdrawal is tax-free and 33 percent is taxable earnings. If you withdraw $10,000, then $6,700 is tax-free and $3,300 is taxable.

This ratio does not change even if the annuity grows or shrinks later. It is locked in when you begin withdrawals. The IRS calls the start of withdrawals the "annuity starting date," and that is when your exclusion ratio is calculated.

When the 10 percent early withdrawal penalty applies

If you withdraw money before you turn 59½, the IRS charges a 10 percent penalty on the earnings portion of the withdrawal. This penalty is in addition to ordinary income tax. Your contribution comes out penalty-free because you already paid tax on it.

There are exceptions to this penalty. You can withdraw without penalty if you are disabled, if you are taking substantially equal periodic payments (a specific IRS formula), or if you are withdrawing after the annuity owner's death. Some annuities also allow a small penalty-free withdrawal each year, though this varies by contract.

The penalty applies only to the taxable earnings, not to your basis. So in the example above, if you withdrew $10,000 before age 59½, you would owe the 10 percent penalty only on the $3,300 earnings portion, which is $330.

The order of withdrawals: why it matters

The IRS has a strict rule about which money comes out first when you withdraw from a non-may have access to annuity: earnings come out before your contribution. This is called the "last-in, first-out" rule for annuities, and it is the opposite of how some other investments work.

This rule is important if you are under 59½ and withdrawing early. Because earnings come out first, your early withdrawals hit the taxable, penalty-prone portion before you touch your contribution. You cannot choose to withdraw your basis first to avoid the penalty. The IRS order is mandatory.

Once you have withdrawn all the earnings, the remaining withdrawals are your contribution and come out tax-free and penalty-free, regardless of your age.

State income tax on non-may have access to annuity withdrawals

In addition to federal income tax, most states tax the earnings portion of non-may have access to annuity withdrawals as ordinary income. The rate depends on your state's tax brackets and your total income for the year. A few states do not have income tax, so residents of those states pay only federal tax on the earnings.

Some states offer special treatment for annuity income, but this is rare and usually applies only to annuities purchased before a certain date or to retirees over a certain age. Check your state's tax authority website or speak with a tax professional to learn what applies to you.

Reporting non-may have access to annuity withdrawals on your tax return

Your annuity company will send you a Form 1099-R each year you take a withdrawal. This form shows the total amount withdrawn and the taxable portion. You report this on your federal tax return, usually on Form 1040 as ordinary income. The form also indicates whether the 10 percent penalty applies, which you report separately.

Keep records of your original contribution amount and any withdrawals you have made over the years. If your annuity company makes an error on the 1099-R, you can request a corrected form. Having your own records helps you verify the calculation and catch mistakes.

Inherited non-may have access to annuities and taxes

If you inherit a non-may have access to annuity, the tax treatment depends on whether you are the spouse of the deceased owner or a non-spouse beneficiary. A surviving spouse can treat the annuity as their own and use the same exclusion ratio. A non-spouse beneficiary must withdraw the entire annuity within a set timeframe (usually five years, though this can vary), and all earnings are taxable as ordinary income.

The original owner's contribution basis does not transfer to you. You pay tax on the full amount of earnings that accrued during the owner's lifetime, even though you did not earn that money. This is one reason some people choose to name their estate or a trust as beneficiary rather than an individual.

Frequently Asked Questions

Do I have to pay tax on my entire non-may have access to annuity withdrawal?

No. Only the earnings portion is taxable. Your original contribution comes out tax-free because you already paid income tax on that money when you earned it. The exclusion ratio determines what percentage of each withdrawal is tax-free.

What happens if I withdraw all my money at once from a non-may have access to annuity?

You pay ordinary income tax on all the earnings in that year, which could push you into a higher tax bracket. You also owe the 10 percent early withdrawal penalty on the earnings if you are under 59½, unless an exception applies. Many people spread withdrawals over time to manage the tax hit.

Can I avoid the 10 percent penalty by taking substantially equal periodic payments?

Yes. If you set up withdrawals using the IRS formula for substantially equal periodic payments (SEPP), you can withdraw before 59½ without the 10 percent penalty. However, you must follow the formula exactly and continue the payments for at least five years or until you turn 59½, whichever is longer.

Is there a difference in how taxes work if my annuity is inside a trust?

The tax treatment of the annuity itself does not change based on who owns it. However, if a trust is the owner, the trust may owe income tax on the earnings instead of you, depending on the trust's structure and whether it distributes the withdrawal to you. Consult a tax professional about your specific situation.

What if my annuity lost money — do I still owe tax?

If your annuity is worth less than your contribution, your exclusion ratio changes. You still use the formula, but now the taxable portion is smaller because there are fewer earnings. If the annuity is worth less than you put in, you have a loss, but you cannot deduct it on your tax return.