Do You Pay Tax on an Annuity? How Taxation Works

Annuities are contracts established with an insurance company designed to provide future payments, often serving as a source of income during retirement. Individuals typically fund these contracts either with a single lump sum or through a series of payments over time. A common question concerns the taxation of these financial products, and generally, the earnings accumulated within an annuity are subject to taxation upon withdrawal.

While contributions to some annuities, known as non-qualified annuities, are made with after-tax dollars, the earnings generated within the contract grow on a tax-deferred basis. This means taxes on the growth are postponed until the money is withdrawn or payments begin. For annuities held within certain retirement plans, referred to as qualified annuities, both the contributions and the earnings are typically taxed when distributions are taken.

Understanding Annuity Taxation Basics

Annuities involve specific tax concepts that differentiate the return of your initial investment from the taxable earnings. The “cost basis,” also known as “investment in the contract,” represents the portion of your contributions that have already been taxed, making it non-taxable when distributed. This figure is the total amount of premiums paid. When you receive distributions, any amount exceeding this cost basis is considered a “taxable gain,” meaning it is subject to income tax.

A significant feature of annuities is their tax-deferred growth, which allows earnings to compound without being taxed until they are withdrawn. This deferral means you are not taxed on interest, dividends, or capital gains as they accrue within the annuity, providing an advantage for long-term savings. The tax is instead paid during the payout phase.

For non-qualified annuities, a specific rule known as “Last-In, First-Out” (LIFO) applies to withdrawals that are not part of a systematic annuitized payout. Under the LIFO rule, earnings are presumed to be withdrawn first and are therefore fully taxable until all accumulated gains have been depleted. Only after all earnings are withdrawn do subsequent distributions represent a return of the non-taxable principal.

When an annuity is “annuitized,” meaning it converts into a stream of regular, periodic payments, the “exclusion ratio” comes into play. This ratio determines the percentage of each payment that is considered a tax-free return of your cost basis. The remaining portion of each payment, representing earnings, is taxable as ordinary income. This ratio is calculated by dividing your initial investment by the total expected return.

Taxation of Non-Qualified Annuities

Non-qualified annuities are funded with after-tax money. Earnings grow tax-deferred during the accumulation phase. When distributions commence, the tax treatment depends on the method of withdrawal.

If annuitized, the exclusion ratio determines the taxable and non-taxable portions of each payment. A calculated percentage of each payment is considered a tax-free return of your original principal, while the remainder, representing earnings, is taxed as ordinary income.

For lump-sum or partial withdrawals, the Last-In, First-Out (LIFO) rule applies. This rule dictates that any earnings accumulated in the account are considered to be withdrawn first. Consequently, these earnings are fully taxable as ordinary income until the entire gain portion of the annuity has been distributed. Only after all earnings have been withdrawn do subsequent distributions become a tax-free return of your original principal.

Early withdrawals from non-qualified annuities, specifically the taxable earnings portion, may incur an additional 10% federal income tax penalty if taken before the annuity owner reaches age 59½. This penalty is applied in addition to regular income taxes on the earnings. However, certain exceptions can waive this penalty, including distributions made due to the owner’s death or disability. Exceptions include distributions due to death, disability, or substantially equal periodic payments.

Taxation of Qualified Annuities

Qualified annuities differ significantly from non-qualified annuities in their tax treatment, primarily due to their funding source and inclusion within a retirement plan structure. These annuities are typically purchased with pre-tax or tax-deductible contributions, often as part of a qualified retirement plan like an Individual Retirement Account (IRA) or a 401(k). The full amount received from a qualified annuity is typically subject to income tax because neither contributions nor earnings were previously taxed.

Qualified annuities are subject to the rules governing the retirement plans in which they are held, including Required Minimum Distributions (RMDs). Once the annuity owner reaches a certain age, currently 73, they must begin taking RMDs from their qualified annuity, regardless of whether they need the income. Failure to take these minimum distributions can result in a significant federal penalty, typically 25% of the amount not withdrawn, which can be reduced to 10% if corrected in a timely manner.

Additionally, distributions from qualified annuities taken before age 59½ are generally subject to a 10% early withdrawal penalty, in addition to being taxed as ordinary income. Similar to non-qualified annuities, certain exceptions, such as death or disability of the owner, may allow for penalty-free withdrawals even before age 59½.

Tax Implications of Specific Events

One such event is a “1035 exchange,” which allows for the tax-free transfer of funds from one annuity contract to another, or even to a life insurance or long-term care insurance policy. This ensures gains are not immediately taxed when the contract is replaced, allowing flexibility. The cost basis from the old contract typically carries over to the new one.

When an annuity owner passes away, the tax treatment of the inherited annuity depends on the beneficiary’s relationship to the deceased and how the payments are taken. Unlike many other inherited assets, annuities generally do not receive a “step-up” in cost basis, meaning the original owner’s tax basis remains the same. For non-qualified annuities, beneficiaries are taxed on the accumulated earnings as ordinary income.

Spousal beneficiaries often have the option to continue the contract as their own, maintaining the tax-deferred status, or they can take distributions subject to their own tax situation. Non-spouse beneficiaries, however, typically have fewer options and must generally distribute the inherited annuity within a certain period, often ten years following the original owner’s death. This “stretch” option allows the beneficiary to spread out the taxable distributions over time, potentially mitigating the tax impact by avoiding a large lump-sum payout. If a lump-sum payment is chosen by any beneficiary, the entire taxable gain is recognized in the year of receipt.

For tax reporting purposes, annuity distributions are generally reported to the Internal Revenue Service (IRS) on Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” This form details the gross distribution, the taxable amount, and any federal income tax withheld, providing the necessary information for beneficiaries or owners to report their annuity income accurately. The responsibility for calculating the taxable portion often falls to the annuity provider, who then furnishes the Form 1099-R to the recipient.