Do You Pay Taxes on Annuities? How Taxation Works

An annuity is a contract with an insurance company, often designed to provide a steady stream of income, particularly during retirement. You contribute funds, and the insurer promises future payments. While annuities offer tax-deferred growth, meaning earnings are not taxed as they accumulate, the income received is generally subject to taxation. The specific timing and nature of this taxation depend on how the annuity was funded and how distributions are taken.

Fundamental Principles of Annuity Taxation

Annuities grow on a tax-deferred basis, meaning interest, dividends, or capital gains earned within the contract are not subject to annual income tax as long as funds remain inside. This allows the money to potentially grow faster due to compounding without yearly tax erosion.

When money is withdrawn from an annuity, only the earnings portion is taxable. The original amount contributed, known as the principal or basis, represents after-tax dollars and is returned tax-free.

For non-qualified annuities, funded with after-tax money, the Internal Revenue Service (IRS) applies the “last-in, first-out” (LIFO) rule for withdrawals. This rule stipulates that earnings are considered to be withdrawn first, making these initial withdrawals fully taxable as ordinary income. Once all accumulated earnings have been withdrawn, subsequent distributions are a tax-free return of your original principal.

Regardless of the underlying investments, annuity earnings are taxed as ordinary income upon withdrawal. This means annuity gains are subject to your regular income tax rates, which can be higher than long-term capital gains rates. This treatment applies even if the annuity invests in assets that would normally generate capital gains outside of an annuity structure.

Tax Implications by Annuity Type

The tax treatment of an annuity depends on whether it is classified as a “qualified” or “non-qualified” contract. Qualified annuities are funded with pre-tax dollars through tax-advantaged retirement accounts, such as IRAs or 401(k)s. Since contributions were not previously taxed, all withdrawals, including principal and earnings, are fully taxable as ordinary income.

Non-qualified annuities are purchased with after-tax dollars. Only the earnings generated within the annuity are subject to taxation upon withdrawal. The principal portion, representing your initial after-tax contributions, is returned tax-free.

While there are various types of non-qualified annuities, such as fixed, variable, and indexed annuities, their fundamental tax treatment of earnings remains consistent. The earnings from these annuities are all taxed as ordinary income and are subject to the LIFO rule upon withdrawal.

The timing of income payments also influences taxation, distinguishing between immediate and deferred annuities. Immediate annuities begin making payments shortly after purchase, and each payment is considered partially taxable earnings and partially a tax-free return of principal. Deferred annuities allow funds to grow tax-deferred for an extended period before payments begin, providing a longer accumulation phase.

Taxation of Annuity Withdrawals and Transactions

When taking partial withdrawals from a non-qualified annuity, the LIFO rule dictates that earnings are taxed first until they are fully depleted. For qualified annuities, any partial withdrawal is fully taxable as ordinary income since the entire contract value originated from pre-tax contributions.

A full surrender of an annuity contract means cashing out the entire value. Any gain—the amount by which the contract’s value exceeds the total premiums paid—is fully taxable as ordinary income. Significant surrender charges may also be imposed by the insurance company, especially if the contract is surrendered early.

When an annuity is annuitized, converting it into a stream of regular income payments, the taxation method changes. For non-qualified annuities, an “exclusion ratio” is used to determine what portion of each payment is a tax-free return of principal and what portion is taxable earnings. This ratio remains constant for the duration of payments. For qualified annuities, every payment received after annuitization is fully taxable as ordinary income.

Annuity death benefits received by beneficiaries are also subject to specific tax rules. For non-qualified annuities, only the gain (the amount exceeding the original principal) is taxable to the beneficiary as ordinary income. For qualified annuities, the entire death benefit is taxable as ordinary income to the beneficiary because the funds were never taxed.

A 1035 exchange allows for the tax-free transfer of funds from one annuity contract to another, provided certain IRS rules are met. This enables contract holders to move their investment without triggering immediate taxation on accumulated gains. The exchange must be a direct transfer between insurance companies, and the owner and annuitant must remain the same.

Withdrawals from an annuity before age 59½ may incur an additional 10% IRS penalty on the taxable portion, on top of regular income taxes. This penalty is designed to discourage early access to funds intended for retirement. Exceptions to this penalty exist, including withdrawals due to disability, substantially equal periodic payments, or certain unreimbursed medical expenses.

Reporting Annuity Income on Your Taxes

Annuity providers are required to report distributions to the IRS and to you using Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.” You typically receive this form by January 31st each year.

Key boxes on Form 1099-R provide essential information for tax reporting. Box 1 shows the gross distribution, which is the total amount received from your annuity during the tax year. Box 2a indicates the taxable amount of the distribution, which is the portion you must include in your gross income. If Box 2a is blank, the payer could not determine the taxable amount, and you will need to calculate it yourself.

Box 4 on Form 1099-R reports any federal income tax withheld from your distribution. Box 7 contains a distribution code, which indicates the type of distribution. This information is then entered on your federal income tax return. Maintaining accurate records of your annuity contributions and distributions is important to correctly determine the taxable portion of your withdrawals.