Are Annuities Taxed as Ordinary Income?
Annuity taxation is nuanced. Your tax liability is determined by the source of funds, withdrawal timing, and how you choose to receive the money.
An annuity is a contract with an insurance company designed to provide income, often for retirement. How these income payments are taxed depends on two main factors: whether the annuity is classified as qualified or non-qualified, and how you receive the money, such as through a lump sum or periodic payments.
Taxation of Non-Qualified Annuities
A non-qualified annuity is funded with after-tax dollars. Because the principal has already been taxed, only the earnings portion of your distributions is subject to ordinary income tax. The return of your original investment, known as the cost basis, is received tax-free.
When you annuitize the contract to create a stream of guaranteed payments, the tax treatment is governed by the exclusion ratio. This calculation determines what portion of each payment is a tax-free return of your principal and what part is taxable earnings. For example, if you invested $100,000 and the total expected return is $150,000, your exclusion ratio is 66.7%. This means 66.7% of each payment is tax-free, and the remaining 33.3% is taxed as ordinary income.
A different set of rules applies if you take withdrawals from a deferred non-qualified annuity before starting periodic payments. These withdrawals are subject to the Last-In, First-Out (LIFO) accounting method. Under LIFO, all withdrawals are considered to come from earnings first. This means 100% of your withdrawal amount is taxable as ordinary income until you have withdrawn all the accumulated gains. Only after all earnings have been distributed can you begin to access your original, tax-free principal.
This LIFO treatment for withdrawals contrasts with the exclusion ratio for annuitized payments. Taking sporadic cash amounts from the annuity can result in a higher immediate tax bill compared to structuring the funds into regular payments. Once you have lived beyond your actuarial life expectancy and have received your entire cost basis back through the exclusion ratio, any subsequent payments become fully taxable.
Taxation of Qualified Annuities
A qualified annuity is held inside a tax-deferred retirement plan, such as a traditional IRA, 401(k), or 403(b). These annuities are funded with pre-tax dollars, meaning no tax has been paid on the contributions or investment gains.
Because no taxes have been paid on any of the funds, 100% of every withdrawal or payment you receive is subject to ordinary income tax. There is no concept of a tax-free return of principal or an exclusion ratio with qualified annuities. Every dollar distributed from the contract is fully taxable at your prevailing income tax rate for the year you receive it.
This treatment aligns with the rules for distributions from traditional retirement accounts, as the annuity follows the tax structure of the plan it is in. The benefit of holding an annuity within a qualified plan is tax-deferred growth, allowing the investment to compound without being annually taxed. The tax is paid when the money is withdrawn, presumably during retirement when your tax bracket may be lower.
Early Withdrawals and Additional Taxes
Beyond the standard income tax, the Internal Revenue Service (IRS) can impose an additional tax on early withdrawals from annuities. This is a penalty intended to discourage the use of retirement savings for non-retirement purposes. Under Internal Revenue Code Section 72, a 10% additional tax is levied on the taxable portion of any distribution received before you reach age 59 ½.
This 10% penalty is applied on top of the ordinary income tax you already owe. For a qualified annuity, the penalty applies to the entire withdrawal amount since it is all taxable. For a non-qualified annuity, the penalty applies only to the earnings portion of the withdrawal.
The tax code provides several exceptions that allow you to avoid this 10% penalty. Common exceptions include distributions made after the annuity owner’s death or on account of the owner’s total and permanent disability. Another exception is for payments made as part of a series of substantially equal periodic payments (SEPP). A SEPP plan allows you to take penalty-free distributions before age 59 ½, provided the payments are based on your life expectancy and continue for at least five years or until you reach age 59 ½, whichever is longer.
Taxation of Inherited Annuities
When a beneficiary inherits an annuity, they must pay ordinary income tax on any untaxed growth in the contract. The original owner’s death does not create a “step-up in basis” for annuities, which means the built-in tax liability passes to the inheritor. The rules and options available depend on whether the beneficiary is a surviving spouse or a non-spousal beneficiary.
A surviving spouse who is the sole beneficiary often has the most flexibility. A common option is to treat the inherited annuity as their own through a process known as spousal continuation. This allows the spouse to step into the shoes of the original owner, continue the contract, and defer the income tax liability until they begin taking withdrawals.
Non-spousal beneficiaries, such as children or other relatives, face more rigid rules and cannot continue the contract as their own. They must begin taking distributions, and a common option is a lump-sum payment. This requires the entire taxable gain to be reported as income in a single year, which can result in a substantial tax bill.
Alternatively, non-spousal beneficiaries of non-qualified annuities may be required to withdraw the full balance within five years of the owner’s death. For annuities held in qualified plans like an IRA, most non-spousal beneficiaries must withdraw the entire account balance within 10 years following the year of the owner’s death. These rules accelerate the recognition of taxable income for the beneficiary.