How Are Immediate Annuities Taxed? What You Need to Know

An immediate annuity is a financial contract where a lump sum payment is exchanged for a series of regular payments that begin almost immediately, typically within one year. These payments can provide a consistent income stream. Understanding the tax implications of these payments is important for managing personal finances.

General Tax Principles for Annuities

Annuity taxation distinguishes between the return of your initial investment, known as the “investment in the contract” or cost basis, and any earnings generated by that investment. The portion of each payment that represents a return of your original principal is generally not taxed. Conversely, the earnings portion of the payment is subject to ordinary income tax.

For non-qualified annuities, funded with after-tax dollars, the Internal Revenue Service (IRS) uses an “exclusion ratio” to determine the taxable and non-taxable portions of each payment. This ratio is calculated by dividing your “investment in the contract” (the total amount paid for the annuity) by the “expected return” (the total amount anticipated over the life of the contract, often calculated using IRS life expectancy tables). Once payments begin, this exclusion ratio remains fixed, applying consistently to each payment received.

Taxation of Non-Qualified Immediate Annuities

Non-qualified immediate annuities are purchased with funds on which taxes have already been paid. The exclusion ratio determines the portion of each income payment that is considered a tax-free return of your original investment. The remainder of each payment, representing the earnings, is subject to ordinary income tax.

For example, if you invest $100,000 in a non-qualified immediate annuity and your expected return is $150,000, your exclusion ratio would be $100,000 divided by $150,000, or approximately 66.67%. If you receive monthly payments of $1,000, then $666.70 (66.67% of $1,000) would be a tax-free return of principal, and $333.30 would be taxable income. This calculation continues until the entire investment in the contract has been recovered.

If an annuitant lives longer than their life expectancy used in the exclusion ratio calculation, any payments received after the entire “investment in the contract” has been returned become fully taxable as ordinary income. Conversely, if an annuitant dies before recovering their full “investment in the contract,” the unrecovered amount may be allowed as an itemized deduction on their final income tax return.

Taxation of Qualified Immediate Annuities

Immediate annuities purchased with pre-tax money from qualified retirement plans, such as 401(k)s or traditional IRAs, are treated differently for tax purposes. Since the original contributions to these plans were made on a pre-tax basis and have not yet been taxed, the entire amount of each payment from a qualified immediate annuity is generally taxable as ordinary income.

Qualified annuities are subject to Required Minimum Distribution (RMD) rules once the annuitant reaches a certain age, currently 73 for most individuals. Payments from an immediate annuity held within a qualified plan can often satisfy these RMD obligations automatically, provided the payment schedule meets or exceeds the calculated minimum distribution. The SECURE 2.0 Act introduced provisions allowing excess income from a qualified annuity to help satisfy RMDs from other qualified accounts under certain conditions.

Tax Reporting and Forms

Annuity providers report distributions to both the annuitant and the IRS. Annuitants receive Form 1099-R, “Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.,” by January 31st of the year following the distributions. This form details the gross distribution amount received from the annuity.

Form 1099-R also specifies the taxable amount of the distribution in Box 2a. In some cases, Box 2b may indicate that the taxable amount has not been determined, requiring the annuitant to calculate it using the exclusion ratio if it’s a non-qualified annuity. This information is then used when filing federal income taxes to report the annuity income.