Annuity payouts are taxed as ordinary income, but only the earnings portion — not your original investment
When you withdraw money from an annuity, the tax treatment depends on whether you're getting back money you already paid taxes on. If you bought the annuity with after-tax dollars (called a non-may have access to annuity), your withdrawals are split into two parts: your original contribution comes out tax-free, and the earnings are taxed as ordinary income at your regular tax rate. If you bought it with pre-tax dollars through an employer plan or IRA (called a may have access to annuity), the entire withdrawal is taxed as ordinary income because you never paid taxes on any of it.
The key difference from capital gains or other investment income is that annuity earnings don't get a lower tax rate just because they came from an investment. They're taxed at whatever your ordinary income tax bracket is — the same rate as wages or salary.
Key Takeaways
- Non-may have access to annuities use a cost-basis method: your contributions return tax-free, but earnings are taxed as ordinary income.
- may have access to annuities (from IRAs or employer plans) tax the entire withdrawal as ordinary income because the original money was never taxed.
- Annuity earnings do not receive capital gains treatment and are not taxed at preferential rates, even though they come from an investment.
- If you withdraw money before age 59½ from a may have access to annuity, you may owe a 10 percent early withdrawal penalty on top of ordinary income tax.
How non-may have access to annuities are taxed
A non-may have access to annuity is one you bought with money that was already yours after paying income tax on it. When you start taking withdrawals, the insurance company uses the exclusion ratio to figure out how much of each payment is your original money and how much is earnings.
The exclusion ratio divides your total contribution by the expected total payout over your lifetime (based on IRS life expectancy tables). That percentage of each payment is tax-free; the rest is taxed as ordinary income. For example, if the ratio is 60 percent, then 60 percent of every payment you receive is your contribution returning to you tax-free, and 40 percent is earnings taxed at your ordinary income rate.
This method continues until you've recovered your entire contribution. After that point, every dollar you receive is taxed as ordinary income.
How may have access to annuities are taxed
A may have access to annuity is one you bought inside a retirement account — an IRA, 401(k), 403(b), or similar plan. Because you contributed pre-tax dollars or the money grew inside a tax-deferred account, you have not yet paid income tax on any of it.
When you withdraw from a may have access to annuity, the entire amount is taxed as ordinary income. There is no cost-basis recovery like there is with non-may have access to annuities. The IRS treats it the same way it treats any withdrawal from a traditional IRA or 401(k): the full withdrawal is ordinary income.
If you withdraw before age 59½, you also owe a 10 percent early withdrawal penalty on top of the ordinary income tax, unless an exception applies (such as disability or a series of substantially equal periodic payments).
Why annuity earnings don't get capital gains rates
Some investments — like stocks held for more than a year or mutual funds — can be taxed at long-term capital gains rates, which are lower than ordinary income rates. Annuities do not receive this treatment, even though you hold them for years or decades.
The reason is structural: annuities are insurance contracts, not securities. The earnings inside an annuity are considered ordinary income by the IRS, regardless of how long you hold the contract. This is one reason annuities are often compared to bonds or CDs in terms of tax efficiency — they're all taxed as ordinary income.
If you own an annuity inside a Roth IRA, the earnings are tax-free when withdrawn (assuming you meet Roth rules), but that's because of the Roth account structure, not because of anything special about the annuity itself.
when ready annuities versus deferred annuities
The tax treatment is the same whether you have an when ready annuity (you buy it and payments start right away) or a deferred annuity (you buy it and let it grow, then take payments later). In both cases, non-may have access to annuities use the exclusion ratio, and may have access to annuities tax the full withdrawal as ordinary income.
The difference is timing. With an when ready annuity, you start receiving payments almost at once, so you begin paying tax on the earnings portion when ready. With a deferred annuity, the money grows tax-deferred inside the contract, but once you start withdrawals, the same tax rules explore.
One exception: if you withdraw from a deferred annuity before the contract matures (before you start the annuitization phase), the earnings are taxed as ordinary income, but you may also owe a surrender charge from the insurance company and possibly a 10 percent IRS penalty if you're under 59½.
Reporting annuity income on your tax return
The insurance company will send you a Form 1099-R each year showing the total amount you withdrew and how much is taxable. For non-may have access to annuities, the form will show the taxable portion separately. For may have access to annuities, the entire distribution is reported as taxable.
You report this income on your tax return in the ordinary income section, not as capital gains. If you're taking distributions from a may have access to annuity and you're under 59½, the form will also flag the 10 percent penalty, which you report separately.
If the insurance company makes an error on the 1099-R, contact them to request a corrected form before filing your return. Do not file based on an incorrect form.
State income tax on annuities
Most states tax annuity income as ordinary income, the same way the federal government does. A few states have no income tax at all (Florida, Texas, Wyoming, and others), so residents of those states pay federal tax but not state tax on annuity withdrawals.
Some states offer tax breaks for retirement income, including annuity payments, but the rules vary widely. If you live in a state with an income tax and receive annuity payments, check your state's tax agency website or speak with a tax preparer to understand how your specific situation is treated.
Frequently Asked Questions
Do I owe taxes on annuity withdrawals if I'm retired?
Yes. Retirement status does not change how annuities are taxed. The earnings portion of a non-may have access to annuity and the entire withdrawal from a may have access to annuity are both taxed as ordinary income, regardless of whether you're working or retired. Your tax bracket may be lower in retirement, which means you'll owe less tax, but the income is still taxable.
What's the difference between an annuity and a CD in terms of taxes?
Both are taxed as ordinary income on the earnings. The main difference is that CDs are FDIC-insured and annuities are not — they're backed by the insurance company's financial strength. Annuities also typically have surrender charges if you withdraw early, while CDs have a straightforward interest penalty. Tax-wise, they're treated the same way.
Can I avoid taxes by keeping money in a deferred annuity?
No. The money grows tax-deferred inside the contract, meaning you don't pay taxes each year on the earnings. But when you withdraw, you owe ordinary income tax on all the earnings at once. You're not avoiding tax — you're deferring it. If you withdraw before 59½, you also owe a 10 percent penalty on the earnings.
Is there a way to get capital gains rates on annuity earnings?
No. Annuities are always taxed as ordinary income, not capital gains, even if you hold them for decades. This is a structural feature of how the IRS treats insurance contracts. If lower tax rates are important to you, other investments like stocks or index funds may be more tax-efficient.
What happens if I inherit an annuity?
The tax treatment depends on the type of annuity and your relationship to the original owner. Generally, if you inherit a non-may have access to annuity, you use the same exclusion ratio method as the original owner. If you inherit a may have access to annuity from a spouse, you can treat it as your own; if from a non-spouse, you must take distributions and pay ordinary income tax on the earnings portion. Consult a tax preparer for your specific situation.