How Does the Annuity Tax Deduction Work?

An annuity is a contract, typically with an insurance company, where you make a payment or series of payments for a future stream of income. These financial products can provide a reliable source of funds during retirement. The tax implications, including whether any part of your contribution is deductible, depend entirely on the type of annuity and how it is funded.

An annuity’s tax treatment hinges on whether it is classified as qualified or non-qualified. This status refers to its treatment under the Internal Revenue Code and is based on the source of funds used for the purchase. The difference lies in whether the money was contributed before or after income taxes were paid, which dictates the tax deduction for contributions and how payments are taxed.

Tax Deductions for Annuity Contributions

Qualified Annuities

A qualified annuity is one purchased within a tax-advantaged retirement plan, such as a traditional 401(k) or a traditional IRA, and is funded with pre-tax dollars. The tax deduction associated with a qualified annuity comes from the contribution to the retirement plan, not the purchase of the annuity itself. For example, when you contribute to a traditional 401(k), that amount is deducted from your taxable income for the year, subject to IRS limits. Using those funds to purchase an annuity is simply an investment choice within the account.

These plans have specific rules, including contribution limits and the requirement that you have earned income to contribute. Owners of qualified annuities are also subject to required minimum distributions (RMDs). These rules mandate that withdrawals must begin once the owner reaches age 73, an age that is scheduled to increase to 75.

Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax dollars, such as funds from a savings or brokerage account. Because the contributions are made with money you have already paid taxes on, there is no upfront tax deduction for the purchase. The tax advantage of a non-qualified annuity is tax-deferred growth, where earnings are not taxed until you begin to withdraw them.

Unlike qualified annuities, non-qualified annuities are not held within an employer-sponsored retirement plan. They also do not have contribution limits or required minimum distributions, offering more flexibility.

Taxation of Annuity Distributions

The tax treatment of payments from an annuity, known as distributions, is a direct consequence of how it was funded. For qualified annuities, since contributions were made with pre-tax dollars and you received a tax deduction, 100% of the distributions are subject to federal income tax. Each payment you receive is taxed as ordinary income at your prevailing tax rate in the year of receipt.

Withdrawals from any annuity before age 59½ may also be subject to a 10% penalty tax from the IRS on the taxable portion of the distribution. This is in addition to regular income tax. This rule is designed to encourage the use of annuities for long-term retirement savings.

For non-qualified annuities, the taxation of distributions is more complex because they are funded with after-tax dollars. You do not pay taxes on the portion of the distribution that represents a return of your original investment, also known as the cost basis. Only the earnings portion of the distribution is taxable as ordinary income. To separate the tax-free principal from the taxable earnings, the IRS uses a method called the exclusion ratio.

The exclusion ratio is a calculation that determines what percentage of each annuity payment is a tax-free return of your investment. It is calculated by dividing your total investment in the contract by the total expected return. For instance, if you invested $100,000 in a non-qualified annuity and your total expected return is $160,000, the exclusion ratio is 62.5%. This means 62.5% of each payment is tax-free, and the remaining 37.5% is taxable until you have recovered your entire investment.

Deducting Losses on an Annuity

A loss on an annuity can be recognized only if you surrender the entire contract for a lump-sum payment that is less than your cost basis—the total of your after-tax premiums. A partial withdrawal or a temporary decline in the annuity’s market value while the contract is active does not create a recognized loss.

However, even if a loss is recognized, it is not deductible. The Tax Cuts and Jobs Act of 2017 suspended miscellaneous itemized deductions, which was the category for these losses. This suspension is in effect through 2025, meaning there is currently no mechanism to deduct such a loss on a personal tax return.

Charitable Gift Annuities and Tax Deductions

A charitable gift annuity (CGA) is an arrangement that is part annuity purchase and part charitable donation. In a CGA, you make a contribution of cash or property to a qualified charity. In return, the charity agrees to pay you, and potentially a second person, a fixed income stream for life.

The primary tax advantage of a CGA is the upfront income tax deduction you can claim in the year you make the gift. The IRS considers the transaction to be split into two parts: a gift to the charity and the purchase of an annuity. You are entitled to a partial tax deduction for the “gift” portion of the transaction, but this is available only if you itemize deductions.

The value of the charitable deduction is calculated by subtracting the present value of the future annuity payments from the total value of the assets you donated. The IRS provides specific actuarial tables to determine the present value based on factors like your age and the payout rate. For example, if you donate $100,000 and the present value of your expected lifetime income is $60,000, you can claim a charitable deduction of $40,000. The deduction for cash gifts is limited to 60% of your AGI, while gifts of appreciated property are subject to lower limits.