- Tax treatment depends first on what money bought the contract: qualified (pre-tax retirement money) or non-qualified (money you already paid tax on).
- Withdrawals from a non-qualified deferred annuity come out interest-first (LIFO), so the first dollars out are fully taxable.
- Annuity gains are taxed as ordinary income, never capital gains — and there is no step-up in basis at death.
- Taxable withdrawals before age 59½ generally carry an extra 10% federal tax on top of ordinary income tax.
- Annuitizing changes the math: the exclusion ratio spreads your cost basis across payments so each one is only partly taxable.
Tax treatment is where most annuity conversations go quiet. The illustration shows growth, the brochure mentions tax deferral, and the actual mechanics of what you will owe and when get compressed into a footnote. This guide covers how annuities are taxed in the situations that actually come up: withdrawing, annuitizing, exchanging, and dying with the contract still in force.
None of this is tax advice for your situation. It is the framework you need to have an informed conversation with someone who can give you that advice.
How is an annuity taxed? The two forks that decide everything
Every answer starts in the same place, so this guide is built as a decision tree rather than a glossary. First fork: qualified or non-qualified? Retirement-plan money is generally taxable in full on the way out; after-tax money is taxable only on the gain. Second fork: are you withdrawing or annuitizing? Withdrawals from a deferred non-qualified contract follow the gain-first rule, so early withdrawals are fully taxable until the gain is exhausted. Annuitized payments follow the exclusion ratio instead, which spreads your basis across the stream and makes a fixed slice of every payment tax-free until the basis is recovered. Locate yourself on those two forks and the rest of this page answers your specific case.
The first question: qualified or non-qualified?
Everything downstream depends on this. A qualified annuity is one held inside a tax-advantaged retirement account — a traditional IRA, a 401(k) rollover, a 403(b). It was funded with pre-tax dollars. A non-qualified annuity was bought with money you had already paid income tax on.
The difference is not cosmetic. In a qualified annuity, you generally have no cost basis, because you never paid tax on the money going in. Withdrawals are therefore taxable essentially in full, and the contract is subject to required minimum distribution rules like any other pre-tax retirement account.
In a non-qualified annuity, the premium you paid is your cost basis. That money has already been taxed once and will not be taxed again. Only the growth above your basis is taxable, and there are no required minimum distributions during your lifetime.
A note worth stating plainly: putting a non-qualified annuity inside an IRA adds no tax benefit, because the IRA already provides deferral. There can be non-tax reasons to do it — a lifetime income guarantee, principal protection — but "for the tax deferral" is not one of them, and it is a claim worth pushing back on if you hear it.
How withdrawals are taxed
For a non-qualified deferred annuity, withdrawals follow what is commonly called LIFO — last in, first out. The IRS treats the first dollars you take out as coming from earnings, not from your original premium.
The practical effect surprises people. If you put in $100,000 and the contract has grown to $140,000, the first $40,000 you withdraw is fully taxable as ordinary income. Only after all $40,000 of gain has come out do you begin recovering your tax-free basis.
This rule applies to contracts purchased after August 13, 1982. Older contracts may follow different ordering, which is one of several reasons a very old annuity should not be exchanged casually.
The pre-59½ penalty
Taxable amounts withdrawn before age 59½ generally carry an additional 10% federal tax on top of ordinary income tax. Exceptions exist — death, disability, and a series of substantially equal periodic payments among them — but they are narrower than people assume, and the penalty applies to the taxable portion only.
Note that this is separate from the carrier's surrender charge. A withdrawal in year three of a ten-year contract can trigger a surrender charge from the insurer, ordinary income tax on the gain, and the 10% federal penalty, all at once. Three different costs, three different recipients.
How annuitized payments are taxed
Annuitizing means converting the account value into a stream of guaranteed payments. It changes the tax math entirely.
Instead of interest-first treatment, the insurer applies an exclusion ratio: the portion of each payment that represents a return of your original premium is excluded from income, and the rest is taxable. If your basis is $100,000 and the expected total of your payments is $250,000, roughly 40% of each payment comes back tax-free.
Two things people miss. First, the exclusion ratio applies only until you have recovered your full basis — if you live past your life expectancy, subsequent payments become fully taxable. Second, in a qualified annuity there is generally no basis to exclude, so the exclusion ratio is not doing anything for you.
The tax breaks annuities do not get
This section matters more than the deferral pitch, and it is the part most often left out.
No capital gains treatment. No matter how the money grew or how long you held it, annuity gains are ordinary income. A brokerage account holding the same investments for the same period would generate long-term capital gains taxed at a lower rate. For someone in a high bracket, that gap can outweigh the value of deferral.
No step-up in basis at death. Appreciated stock passed to an heir gets its basis reset to the date-of-death value, wiping out the embedded gain. An annuity does not. Your beneficiary inherits your original basis and owes ordinary income tax on every dollar of gain as they receive it.
No qualified dividend treatment. Dividends generated inside a variable annuity's subaccounts lose their qualified status. They come out as ordinary income like everything else.
Deferral is genuinely valuable in some situations — high current bracket, expectation of a lower bracket in retirement, a long runway. It is much less valuable, and sometimes negative, when the alternative is a low-turnover taxable portfolio held for decades and passed to heirs.
Taxes on exchanges
Section 1035 of the tax code permits a tax-free exchange from one annuity to another, provided the owner stays the same and the funds move directly between carriers. Done properly, nothing is recognized as income and your original cost basis carries forward.
Done improperly — by surrendering the old contract, taking a check, and buying a new one — the entire gain becomes taxable immediately. The distinction is procedural and unforgiving. Our 1035 exchange guide covers the mechanics and the trap.
Taxes on death benefits
When an annuity owner dies with gain in the contract, that gain does not disappear. It becomes what the tax code calls income in respect of a decedent, and the beneficiary owes ordinary income tax on it as it is paid out.
Spousal beneficiaries usually have the option to continue the contract as their own and keep deferring. Non-spouse beneficiaries face distribution deadlines set by the contract and by Section 72(s) of the code. The choices made in the first year matter a great deal, and they are largely irreversible. Our annuity death benefit guide walks through them.
What to actually do with this
Three questions worth asking before you sign anything, and before you touch a contract you already own:
What is my cost basis, in dollars, right now? The carrier can tell you. Every tax calculation you will ever do on this contract starts there.
What bracket am I in now versus what bracket do I expect at withdrawal? Deferral is a bet that the second number is lower. If it is not, deferral converts what would have been capital gains into ordinary income at a higher rate — the opposite of the intended effect.
Who inherits this, and what will it cost them? The absence of a step-up in basis lands on your beneficiary, not on you. If leaving assets efficiently is a priority, this belongs in the decision.
Frequently asked
Not sure what your contract will actually cost you in tax?
Tax treatment turns on details buried in your contract and on how the money got there. Get an independent read before you withdraw, exchange, or annuitize.
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