Are Annuities Taxable? How Annuity Income Is Taxed

An annuity is a contract between an individual and an insurance company, designed to provide a steady stream of income, often during retirement. Individuals typically make a lump-sum payment or a series of payments to the insurer. While the funds within an annuity grow on a tax-deferred basis, the income received is generally subject to taxation. The specific tax treatment depends on how the annuity was funded and how distributions are taken.

How Non-Qualified Annuities Are Taxed

Non-qualified annuities are funded with after-tax dollars. The earnings generated within these annuities grow tax-deferred.

When distributions are taken from a non-qualified annuity before annuitization, the IRS generally applies a “Last-In, First-Out” (LIFO) rule. This rule dictates that earnings are withdrawn first, making them taxable as ordinary income before any return of the tax-free principal (cost basis) is received. Once earnings have been fully withdrawn and taxed, subsequent withdrawals are treated as a tax-exempt return of the original principal.

For non-qualified annuities that are annuitized, a different tax calculation applies, known as the “exclusion ratio.” This ratio determines the portion of each payment that is considered a tax-free return of principal and the portion that is taxable earnings. The exclusion ratio prevents double taxation of the original after-tax contributions. The calculation considers the amount paid into the annuity (cost basis) and the expected total return.

How Qualified Annuities Are Taxed

Qualified annuities are held within tax-advantaged retirement accounts, such as traditional Individual Retirement Arrangements (IRAs) or 401(k) plans. These annuities are typically funded with pre-tax contributions. As a result, both contributions and any earnings within the annuity grow tax-deferred.

When distributions are taken from a qualified annuity, the entire amount received is generally taxable as ordinary income. This is because no taxes were paid on the funds before they were contributed or as they grew within the annuity. The tax rules of the underlying retirement account, such as required minimum distributions (RMDs) starting at age 73, typically apply to these annuities.

A notable exception is an annuity held within a Roth IRA or Roth 401(k), which is funded with after-tax contributions. Provided certain requirements are met, distributions from such annuities are usually tax-free, similar to other Roth account distributions. This contrasts with non-qualified annuities, where only the earnings portion is taxed, as the principal was already taxed.

Other Taxable Annuity Transactions

Beyond regular income distributions, several other annuity transactions can trigger tax implications. Early withdrawals, defined as distributions taken before age 59½, are one common scenario. The taxable portion of such a withdrawal is subject to ordinary income tax. The IRS imposes a 10% federal tax penalty on the taxable amount of these early withdrawals, unless a specific exception applies.

Inherited annuities also have specific tax rules for beneficiaries. The tax treatment depends on whether the annuity was qualified or non-qualified and the beneficiary’s relationship to the deceased owner. For qualified annuities, beneficiaries must pay ordinary income tax on distributions, and most non-spousal beneficiaries are subject to the 10-year rule introduced by the SECURE Act. Spouses and certain other eligible designated beneficiaries may have more flexible payout options.

For inherited non-qualified annuities, only the earnings are taxable to the beneficiary. Non-spousal beneficiaries often face a five-year rule, though some may stretch payments over their life expectancy. The specific payout option chosen by the beneficiary, such as a lump sum or periodic payments, influences the timing of tax liability.

Internal Revenue Code Section 1035 allows for a tax-free transfer of funds from one annuity contract to another, or from certain other insurance policies to an annuity. This provision enables policyholders to switch contracts without triggering immediate income tax on any accumulated gains. The cost basis from the original annuity carries over to the new contract, preserving the tax-deferred status of the earnings. While the exchange itself is tax-free, surrender charges from the old annuity or new fees on the new contract may still apply.

Reporting Annuity Income

Annuity payments and distributions are reported to the IRS on Form 1099-R. The insurance company or financial institution issuing the annuity is responsible for sending this form to the recipient and the IRS annually. Recipients typically receive a Form 1099-R if they received distributions of $10 or more during the tax year.

Form 1099-R provides specific details necessary for tax filing. Key information includes the gross distribution amount in Box 1 and the taxable amount in Box 2a. Box 2b indicates whether the taxable amount was not determined by the payer or if it represents a total distribution. Box 4 shows any federal income tax withheld from the distribution, which should be reported as tax withheld on an individual’s tax return.

Box 7 contains a distribution code that clarifies the type of distribution, such as a normal distribution or a 1035 tax-free exchange. For non-qualified annuities, individuals should maintain records of their cost basis. This information helps in accurately determining the non-taxable portion of distributions, especially if it is not fully detailed on the Form 1099-R. The information from Form 1099-R is then used to report the annuity income on an individual’s federal income tax return, typically Form 1040.