How Annuities Are Taxed

The basic rule for annuity taxation is straightforward: growth inside the contract is not taxed until withdrawn. The complications come from how withdrawals are characterized, whether the contract was funded with pre-tax or after-tax money, and the timing of distributions relative to the IRS’s age and RMD rules.

This article documents the rules in plain English. It does not replace a tax advisor, and the rules are subject to legislative change.

The core principle: tax deferral

All annuity types (fixed, MYGA, FIA, SPIA, DIA, variable, QLAC) defer taxes during the accumulation phase. Interest credits, subaccount growth, and dividend equivalents inside the contract are not taxable in the year earned.

This is structurally different from a bank CD or a taxable brokerage account, where interest and dividends are taxed in the year earned regardless of whether they are withdrawn.

The deferral applies until the consumer takes a withdrawal. At that point, the gain portion of the withdrawal becomes taxable.

Qualified vs non-qualified contracts

The first tax classification is whether the annuity was funded with qualified or non-qualified money.

Qualified annuity. Funded with pre-tax retirement money via rollover or direct transfer from an IRA, 401(k), 403(b), or 457(b). The entire premium represents pre-tax dollars. There is no after-tax basis.

Non-qualified annuity. Funded with after-tax money — savings, taxable brokerage account proceeds, inheritance. The premium represents after-tax basis. Only the gain (interest credited inside the contract) is taxable when withdrawn.

The tax treatment of withdrawals differs significantly between the two.

Non-qualified withdrawal taxation: LIFO ordering

When a consumer withdraws from a non-qualified annuity before annuitization, the IRS uses LIFO (Last In, First Out) ordering. Earnings come out first and are fully taxable. Basis comes out only after all earnings have been withdrawn.

Example. A consumer pays $100,000 of after-tax money into a non-qualified MYGA. After 5 years, the contract is worth $130,000 (basis $100,000 + gain $30,000). They withdraw $40,000.

• The first $30,000 is treated as gain. Fully taxable as ordinary income.
• The next $10,000 is treated as return of basis. Not taxable.

After the withdrawal, the contract holds $90,000, all of which is basis. Subsequent withdrawals are nontaxable until the basis is exhausted.

LIFO ordering does not apply to annuitized payments (see exclusion ratio below).

Non-qualified annuitized payments: exclusion ratio

When a non-qualified annuity is converted to a stream of payments through annuitization (or via a SPIA / DIA payout), the exclusion ratio determines how much of each payment is return of basis (nontaxable) vs gain (taxable).

The exclusion ratio is calculated at the time annuitization begins:

Exclusion ratio = Investment in the contract ÷ Expected total return

For a non-qualified SPIA purchased for $100,000 that is expected to pay $620 per month for the annuitant’s expected life of 20 years:

• Investment in the contract: $100,000
• Expected total return: $620 × 12 × 20 = $148,800
• Exclusion ratio: 100,000 ÷ 148,800 = 67.2%

Each $620 payment is split: $416.65 (67.2%) is non-taxable return of basis, $203.35 is taxable interest. This treatment applies until the consumer has fully recovered their basis. Once the basis is exhausted, the full payment becomes taxable.

The exclusion ratio is set at annuitization and does not change. The consumer’s actual lifespan does not affect the math (other than by extending taxable payments past the basis-recovery point).

Qualified withdrawal taxation

Qualified annuity withdrawals follow standard IRA rules. Since the entire premium is pre-tax, the entire withdrawal is taxable as ordinary income. No exclusion ratio applies. No LIFO ordering applies.

Qualified annuities are subject to Required Minimum Distributions (RMDs) starting at age 73 (rising to 75 in 2033 under SECURE 2.0). The annuity payments themselves count toward RMDs.

A QLAC is a special case. The QLAC premium is excluded from the IRA balance used to calculate RMDs until QLAC income begins. This is the QLAC’s primary tax feature, allowing deferral of taxable income to a later age.

The 10% pre-59½ penalty

Withdrawals from any annuity before the contract owner reaches age 59½ may incur a 10% federal tax penalty on the gain portion, in addition to ordinary income tax.

Exceptions include:

• Death of the contract owner
• Disability of the contract owner
• Substantially equal periodic payments (SEPP) under IRC §72(q)
• Annuitization (immediate payments under a lifetime contract typically qualify)

The penalty applies only to the taxable portion of the withdrawal. For a non-qualified annuity, that means only the gain. For a qualified annuity, the entire withdrawal is subject to the penalty.

This rule mirrors the IRA early-withdrawal penalty and is one of the structural reasons annuities are best matched to consumers near or past age 59½.

1035 exchanges: moving annuities tax-free

IRC Section 1035 allows the consumer to exchange one non-qualified annuity for another non-qualified annuity without triggering tax on the gain. The basis carries over to the new contract.

The exchange is also available for:

• Exchange of an annuity for another annuity
• Exchange of a life insurance contract for an annuity
• Exchange of a long-term care contract for another long-term care contract

A 1035 exchange must be a direct transfer between carriers. The consumer cannot take possession of the funds. If they do, the IRS treats the transaction as a taxable surrender plus a separate new purchase, not as a 1035 exchange.

Surrender charges from the original contract may still apply. The new contract resets the surrender period and may carry its own surrender schedule.

Death benefit taxation

When the contract owner dies, the death benefit paid to beneficiaries has its own tax treatment.

Non-qualified death benefit. The gain portion is taxable to the beneficiary as ordinary income. The basis is recovered tax-free. Spousal beneficiaries can typically continue the contract in their own name, deferring the tax. Non-spouse beneficiaries usually face a 5-year or 10-year distribution requirement (SECURE Act rules).

Qualified death benefit. Inherited IRA rules apply. The full distribution is taxable as ordinary income. Non-spouse beneficiaries are subject to the 10-year rule.

Annuities inside IRAs

Placing an annuity inside an IRA is allowed but is structurally redundant for the tax-deferral feature. The IRA already provides tax deferral. Putting a tax-deferred annuity inside a tax-deferred account adds no tax benefit.

The only reasons to place an annuity inside an IRA are:

• The annuity’s income guarantee or principal protection feature is valuable
• The QLAC structure (RMD reduction up to $200,000)
• Specific contract features not available outside an IRA

A variable annuity recommendation inside an IRA, sold for “tax deferral,” is one of the clearest red flags in annuity sales. The IRA already provides the deferral; the annuity’s M&E and rider fees add cost without adding the tax benefit.

State taxation

State tax treatment of annuities generally follows federal treatment but with state-specific rules. Some states tax annuity payments differently from federal treatment. Some states exempt a portion of retirement income from state income tax, which can affect the after-tax outcome.

Verify with a state-specific tax advisor before assuming federal rules apply at the state level.

Sources to verify

This article covers the general rules as of 2026. For authoritative reference:

• IRS Publication 590-B (Distributions from Individual Retirement Arrangements)
• IRC Section 72 (annuity tax rules)
• IRC Section 1035 (tax-free exchanges)
• State department of revenue resources for state-level treatment

For a tax decision on a specific contract, consult a CPA or tax attorney. The rules above are general guidance, not tax advice.