When Do You Pay Taxes on an Annuity?

Annuities are financial contracts issued by insurance companies, designed to provide a steady income stream, often for retirement. They involve an agreement where an individual makes payments for future disbursements. Understanding annuity taxation is important, as tax implications depend on funding and distribution timing.

Fundamental Tax Distinctions for Annuities

The tax treatment of annuities distinguishes between qualified and non-qualified contracts.

Qualified annuities are funded with pre-tax dollars, often through retirement plans like IRAs or 403(b)s. All future distributions are subject to ordinary income tax.

Non-qualified annuities are funded with after-tax dollars. Only the earnings portion of distributions is taxable, while the return of the principal is not.

Annuities are also distinguished by whether they are immediate or deferred. Immediate annuities begin payments soon after purchase. Deferred annuities include an accumulation phase where funds grow before distributions begin at a later date.

Tax deferral applies to earnings within the contract. Interest, dividends, or capital gains generated by the annuity’s investments are not taxed annually. Instead, taxes on this growth are postponed until withdrawals or distributions. This deferral allows earnings to compound without immediate tax liabilities.

Taxation During the Annuity Accumulation Phase

During the accumulation phase of a deferred annuity, tax rules apply to contributions and investment growth.

For qualified annuities, contributions are made with pre-tax dollars, often from gross income or employer-sponsored plans. These contributions are not taxed when made.

Contributions to non-qualified annuities are made with after-tax dollars. This principal amount forms the basis for future tax-free return of capital.

The accumulation phase benefits from tax-deferred growth of earnings within the annuity contract. As funds grow through interest, dividends, or capital gains, these earnings are not subject to annual income tax. This tax deferral allows the investment to compound more rapidly. Taxes on this growth are only triggered when funds are withdrawn or distributed.

Taxation During the Annuity Distribution Phase

The distribution phase is when the annuity holder begins to receive payments, and tax liabilities arise.

When a non-qualified annuity is annuitized, a portion of each payment is a tax-free return of principal, and the rest is taxable earnings. This is determined by the “exclusion ratio,” which divides the after-tax contributions by the total expected return. For example, if an individual invested $100,000 and expects to receive $200,000, 50% of each payment would be tax-free. Taxes are paid on the earnings as they are received.

For qualified annuities, the entire amount of each payment received during the distribution phase is taxable as ordinary income. This is because contributions were made with pre-tax dollars, meaning the full distribution is added to the annuitant’s gross income in the year it is received.

When an annuity is surrendered for a lump sum or partial withdrawals, different tax rules apply. For non-qualified annuities, the “income first” rule (LIFO) governs taxation. Withdrawals are considered earnings first, fully taxable as ordinary income until all accumulated earnings are withdrawn. Once earnings are depleted, subsequent withdrawals are a tax-free return of the original, after-tax principal.

In contrast, all lump-sum withdrawals or partial surrenders from a qualified annuity are fully taxable as ordinary income. Since these annuities were funded with pre-tax contributions, there is no “cost basis” or after-tax principal to be returned tax-free. Any money withdrawn from a qualified annuity is considered taxable income.

Other Taxable Annuity Events

Beyond the regular accumulation and distribution phases, other events trigger tax implications. An early withdrawal is taking money from an annuity before age 59½. In addition to regular income tax, these early distributions may incur a 10% additional tax, a penalty. This penalty discourages using annuities as short-term savings vehicles and applies to the taxable portion of the withdrawal.

A 1035 exchange allows the tax-free transfer of funds from one annuity contract to another, or from a life insurance policy to an annuity, without triggering a taxable event. This lets individuals move annuity assets to a different contract without immediate tax liabilities on accumulated gains. Specific IRS rules must be followed for like-kind exchanges.

Death benefits from an annuity also have tax consequences for beneficiaries. When an annuity owner dies, the earnings portion of the annuity’s value is taxable to the beneficiary. Tax treatment varies based on the beneficiary’s relationship and distribution method. For example, a surviving spouse may continue the contract, deferring taxes, while non-spouse beneficiaries face taxation on earnings when they receive distributions, whether as a lump sum or over time.