What Is the Tax Treatment of a Non-Qualified Annuity?

A non-qualified annuity is a financial contract with an insurance company funded with after-tax dollars. This means the money used to purchase the annuity has already been subject to income tax, which shapes how funds are treated when withdrawn. Unlike qualified annuities, you do not get an upfront tax deduction for contributions to a non-qualified annuity. The benefit of tax deferral applies to the growth within the contract, so you do not pay taxes on the earnings each year as they accumulate. Taxation occurs only when money is taken out, and only the earnings portion is subject to income tax.

The Core Tax Principle for Withdrawals

When taking withdrawals from a non-qualified annuity before annuitization, the Internal Revenue Service (IRS) applies the Last-In, First-Out (LIFO) method. Under the LIFO principle, all withdrawals are considered to come from the accumulated earnings first. Consequently, the initial distributions you receive are fully taxable as ordinary income until all the gains have been paid out.

Only after you have withdrawn all the earnings do you begin to receive your original investment, known as the cost basis, which is returned tax-free. For example, if an annuity purchased with $100,000 of after-tax money grows to a value of $140,000, it has $40,000 of earnings. If you take a $50,000 withdrawal, the first $40,000 is considered earnings and is fully taxable, while the remaining $10,000 is a tax-free return of your principal.

An additional tax consideration is a potential penalty. If you take a distribution from the taxable portion of your annuity before reaching age 59 ½, you will face a 10% early withdrawal penalty from the IRS on top of regular income tax. There are exceptions to this penalty, such as distributions made due to the owner’s death, disability, or if the payments are part of a series of substantially equal periodic payments.

Taxation of Annuitized Payments

When you convert your non-qualified annuity into a series of guaranteed income payments, a process known as annuitization, the tax treatment changes. Instead of the LIFO method, the IRS uses the “Exclusion Ratio” to determine the tax liability of each payment. This calculation separates each payment into two parts: a tax-free return of your original investment (the principal) and a taxable portion representing the earnings.

The exclusion ratio is calculated by dividing your total investment in the contract by the total expected return. The investment is the sum of premiums you paid, and the expected return is the total amount you anticipate receiving. This is determined by the insurance company using IRS actuarial tables that factor in your life expectancy for lifetime payments or the fixed term for period-certain payments.

To illustrate, assume you invested $120,000 into an annuity and your total expected return is calculated to be $200,000. The exclusion ratio would be 60% ($120,000 ÷ $200,000). If your monthly annuity payment is $1,000, $600 of each payment is a tax-free return of your principal (60% of $1,000), while the remaining $400 is taxable as ordinary income.

This treatment continues until you have recovered your entire investment. If you live beyond your projected life expectancy and have received your full cost basis back, any subsequent payments you receive will be fully taxable. If payments cease due to death before the full cost basis is recovered, the unrecovered portion may be allowed as a deduction on the final income tax return.

Tax Rules for Beneficiaries

When an individual inherits a non-qualified annuity, the tax consequences for the beneficiary depend on their relationship to the original owner. A surviving spouse who is the beneficiary has the most flexibility and can elect to treat the inherited annuity as their own. This “spousal continuation” allows the spouse to step into the shoes of the original owner, continue the contract, and maintain its tax-deferred status.

Non-spousal beneficiaries face a different set of rules and must distribute the proceeds from the annuity. One common method is the five-year rule, which mandates that the entire balance of the annuity must be withdrawn within five years of the owner’s death. The beneficiary can take the funds as a lump sum or in smaller increments over that period, with the earnings portion of each withdrawal being taxed as ordinary income.

Another option for non-spousal beneficiaries is to receive the death benefit in payments over their own life expectancy. This “stretch” provision allows the beneficiary to take distributions as a series of annuitized payments, spreading the tax liability over many years. Inherited non-qualified annuities do not receive a “step-up” in basis, meaning the beneficiary is responsible for the income tax on the contract’s gains.

Reporting Annuity Income

When you receive a distribution from a non-qualified annuity, the insurance company is required to report the payment to you and the IRS using Form 1099-R. You will receive this form by the end of January following the year of the distribution. The form provides the necessary details to accurately report the income on your tax return.

Form 1099-R contains several boxes that summarize the distribution. Box 1 shows the gross distribution, which is the total amount of money you received from the annuity. Box 2a specifies the taxable amount of the distribution, which represents the earnings portion of the payment that is subject to ordinary income tax.

You must report the figures from Form 1099-R on your federal income tax return, Form 1040. The gross distribution from Box 1 is reported on line 5a of Form 1040, and the taxable amount from Box 2a is reported on line 5b. If federal income tax was withheld from your distribution, this amount will appear in Box 4, and you should report it as tax paid on your return.