How are annuities taxed? It depends on the type of money you use (IRA/401(k) vs. non-qualified cash), whether you take withdrawals or annuitize for income, and who receives the proceeds. Below we explain the major rules in plain English and walk through examples so you can see how annuity taxes work in real life.

How Annuities Are Taxed: The Big Picture

  
• Qualified annuities (IRA/401(k) money): Distributions are generally fully taxable as ordinary income. They may count toward required minimum distributions (RMDs) once you reach the applicable age under current IRS rules.
  
• Non-qualified annuities (after-tax money): Growth is tax-deferred. When you take money out, taxation depends on how you access the contract:     
        
  • Withdrawals/partial surrenders: Usually “LIFO” — earnings come out first and are taxable until all growth is withdrawn; basis comes out last and is not taxed.
        
  • Annuitization for a period or life: Each payment is part tax-free return of basis and part taxable income using the IRS exclusion ratio. After basis is fully recovered, payments become fully taxable.
      
    
  
• Early distributions: Taxable amounts taken before age 59½ may incur an additional 10% IRS penalty (exceptions apply under IRS rules).
  
• Transfers: Non-qualified annuities can move tax-free via a 1035 exchange (annuity → annuity). Qualified annuities use trustee-to-trustee transfers/rollovers (not 1035).
  
• Beneficiaries: For non-qualified contracts, gains are taxable to heirs as ordinary income; there’s generally no step-up in basis on annuities.

Taxes on Non-Qualified Annuities (After-Tax Money)

Non-qualified annuities are popular because growth compounds without annual taxation. The trade-off is that gains are taxed as ordinary income when accessed.

Example 1 — Non-Qualified Withdrawal (LIFO)

Facts: You deposited $100,000. It grew to $130,000. You take a $20,000 withdrawal at age 65.
Tax result: The first $20,000 is treated as earnings under LIFO, so it’s fully taxable as ordinary income. Your remaining contract value is $110,000 with $10,000 of untaxed gain.

Example 2 — Non-Qualified Annuitization (Exclusion Ratio)

Facts: Deposit $120,000 to a Single Premium Immediate Annuity (SPIA) paying $9,600/yr for 20 years (period certain).
Simple illustration: Expected return = $9,600 × 20 = $192,000. Exclusion ratio = Basis ÷ Expected return = $120,000 ÷ $192,000 = 62.5%.
Tax result: Each payment: $6,000 (62.5%) is tax-free return of basis; $3,600 (37.5%) is taxable. After 20 years, basis is fully recovered.

Taxes on Qualified Annuities (IRA/401(k) Money)

  
• Traditional IRA/401(k): Distributions are generally 100% taxable as ordinary income. If you annuitize inside the IRA, payments still count as IRA distributions for tax purposes.
  
• RMD coordination: Annuities held in IRAs are subject to RMD rules. Many fixed annuities allow RMD-friendly withdrawals without surrender charges.
  
• Roth IRA annuities: Qualified distributions are generally tax-free (subject to IRS 5-year and age rules).

Example 3 — IRA Annuity and RMDs

Facts: $250,000 IRA fixed annuity. Your annual RMD for all IRAs is $10,000.
Tax result: You can take the RMD from the annuity (often penalty-free under RMD provisions) or from another IRA. The amount you withdraw is taxable; the annuity can continue.

Income Riders & Lifetime Withdrawals

If you add a lifetime income rider to a fixed indexed annuity (FIA), the guaranteed withdrawal you receive each year is generally taxed like withdrawals from that type of contract:

  
• Non-qualified FIA + rider: Withdrawals are typically treated as gains first (taxable) until all growth has been distributed; thereafter, you tap basis tax-free.
  
• Qualified (IRA) FIA + rider: Amounts withdrawn are generally fully taxable, just like other IRA distributions.

Want a deeper dive? See What Is a Fixed Indexed Annuity with an Income Rider?

Death Benefits & Beneficiaries

  
• Non-qualified annuity: Beneficiaries owe ordinary income tax on the gain portion they receive. The original after-tax basis is returned tax-free; there’s typically no step-up.
  
• Qualified annuity (IRA): Inherited distributions are taxable to the beneficiary and follow current IRA beneficiary rules.

1035 Exchanges & Tax-Efficient Upgrades

You can move a non-qualified annuity to another annuity via a 1035 exchange without triggering current tax on gains (basis and gain carry over). Investors use 1035s to improve crediting rates, add features, or simplify contracts. For IRA annuities, use a trustee-to-trustee transfer.

Fixed vs FIA vs SPIA: Tax Treatment at a Glance

More Examples (Quick Hits)

  
• Example 4 — Early withdrawal at 57 (non-qualified): Taxable portion is ordinary income plus potential 10% additional tax. After 59½, the additional 10% generally no longer applies.
  
• Example 5 — Roth IRA annuity: If you meet IRS Roth rules (age + 5-year), qualified distributions are generally tax-free.
  
• Example 6 — Spousal continuation: Some contracts allow a spouse beneficiary to continue the annuity and defer taxes on gains until later distributions, subject to contract and IRS rules.

FAQs: How Are Annuities Taxed?