How Is Annuity Interest Taxed During the Accumulation Period?

An annuity is a contract with an insurance company for long-term financial planning. The owner makes either a single payment or a series of payments to the insurer, and in return, the company commits to making future payments back. The time during which the owner contributes funds and the contract’s value increases is the accumulation period.

During the accumulation period, any interest, dividends, or capital gains credited to the annuity grow within the contract. The tax treatment of this growth is a specific feature of these financial products. Only deferred annuities, which postpone payouts to a future date, have an accumulation phase.

The Principle of Tax-Deferred Growth

The tax characteristic of an annuity during its accumulation period is tax deferral. This means earnings generated within the contract, such as interest or investment gains, are not subject to income tax in the year they are earned. This treatment differs from standard taxable accounts, where income is reported annually on forms like the 1099-INT or 1099-DIV and taxed immediately. In an annuity, taxes are postponed until the owner withdraws money, allowing funds to grow without being reduced by annual tax payments.

The advantage of tax deferral is that earnings can compound more rapidly. Since money that would have been paid in taxes remains invested, it continues to generate its own earnings. For example, a $100,000 investment earning 6% annually in a taxable account with a 24% tax rate would have its $6,000 gain reduced by $1,440 in taxes. In a tax-deferred annuity, the full $6,000 is reinvested, allowing faster growth.

This compounding can lead to a larger accumulation of funds over the long term compared to an investment that is taxed annually. Tax deferral is a postponement of taxes, not an elimination of them. The tax liability is shifted to a future date upon withdrawal.

Taxation of Withdrawals Before Annuitization

Taking a withdrawal during the accumulation period triggers immediate tax consequences. For non-qualified annuities, the Internal Revenue Service (IRS) applies the Last-In, First-Out (LIFO) rule, meaning earnings are withdrawn first. The initial portion of any withdrawal is fully taxable as ordinary income up to the total gain the annuity has generated.

For example, if an annuity funded with $100,000 has grown to $125,000, the first $25,000 withdrawn is taxable earnings. After all gains are distributed, the owner can withdraw their original investment, or cost basis, tax-free.

Withdrawals made before the owner reaches age 59 ½ are also subject to a 10% early withdrawal penalty. This penalty applies only to the taxable portion of the withdrawal. Using the previous example, a pre-59 ½ withdrawal of $10,000 would be subject to both ordinary income tax and a $1,000 penalty.

Exceptions to the 10% penalty exist, and the penalty is waived for:

• The owner’s death or disability
• Withdrawals that are part of a series of substantially equal periodic payments
• Funds used for qualified higher education expenses
• Medical costs exceeding 7.5% of adjusted gross income
• Health insurance premiums during unemployment

Distinctions for Qualified vs. Non-Qualified Annuities

The tax rules for withdrawals are influenced by whether an annuity is qualified or non-qualified, which depends on the source of funds. A non-qualified annuity is funded with after-tax dollars, meaning the owner has already paid income tax on the money. Therefore, only the earnings are taxed upon withdrawal, as the principal is a return of already-taxed money.

A qualified annuity is funded with pre-tax dollars and held within a tax-advantaged retirement plan, like a Traditional IRA or a 401(k). Because contributions were made before income tax was paid, both the contributions and the earnings have a $0 tax basis.

For a qualified annuity, 100% of any distribution is taxable as ordinary income. Since neither the principal nor the growth has been taxed, the entire amount withdrawn is included in the owner’s gross income for that year. The tax rules of the retirement plan override the standard annuity tax rules.

The 10% early withdrawal penalty for distributions before age 59 ½ applies to the taxable portion of withdrawals from both types. For a non-qualified annuity, the penalty applies only to the earnings portion. For a qualified annuity, the penalty applies to the entire withdrawal, since the full distribution is taxable.

Tax Implications at Death During Accumulation

If the annuity owner dies during the accumulation period, the tax-deferral benefit ceases. The designated beneficiary must then pay ordinary income tax on the gains within the contract. The rules for distributions and taxes depend on the annuity type and the beneficiary’s relationship to the owner.

For non-qualified annuities, a non-spouse beneficiary can choose a lump-sum distribution, making the entire gain taxable in one year. They can also take distributions over a set period, such as five years.

For qualified annuities, the SECURE Act established a 10-year rule for most non-spouse beneficiaries. This requires the entire account balance to be distributed by the end of the 10th year following the owner’s death. Exceptions exist for “eligible designated beneficiaries,” such as those who are disabled, chronically ill, or not more than 10 years younger than the owner, who may have more flexibility.

Spousal beneficiaries have the most favorable options. A surviving spouse can treat an inherited annuity as their own through spousal continuation. This allows tax deferral to continue until the surviving spouse begins taking withdrawals.