Annuity cost basis is one of the most important (and most misunderstood) concepts in retirement planning because it helps determine how much of your annuity withdrawals may be taxable. In simple terms, your cost basis is the amount of money you put into the annuity using after-tax dollars—your original premium, plus any additional after-tax contributions—minus any amounts you’ve already taken out tax-free as a return of principal. The difference between your account value and your cost basis is your gain, and that gain is usually the part that becomes taxable when you take withdrawals. If you’re trying to understand what you actually “own,” what you can access, and what portion of distributions the IRS may treat as income, understanding cost basis is the starting point.

At Diversified Insurance Brokers, we see cost basis questions come up in the exact moments when clarity matters most: when someone is about to start retirement income, when they inherit an annuity, when they want to move money via a 1035 exchange, or when they’re trying to avoid a surprise tax bill after taking a large withdrawal. Cost basis is not just a tax term—it’s a planning tool that helps you understand how to sequence withdrawals, how to compare annuity income options, and how to coordinate annuity distributions with other retirement income sources.

It’s also important to understand what cost basis is not. Cost basis is not the same as your annuity’s current value, and it’s not a “special account” you can withdraw from separately. It’s simply a way to track your after-tax principal versus your taxable gain. That distinction matters because annuities are generally taxed differently depending on whether the money is inside an IRA (qualified) or outside an IRA (non-qualified). In many cases, confusion happens because people mix up IRA rules with non-qualified annuity rules. This page will walk through both in plain English, with examples that show how it works in the real world.

Definition: What Is Annuity Cost Basis?

Annuity cost basis is the total amount of after-tax money you have paid into a non-qualified annuity, adjusted for any tax-free return of principal you have already received. Think of it as your “principal” in the contract. If you put $200,000 of after-tax money into an annuity and the annuity is now worth $260,000, then your cost basis is generally $200,000 and your gain is $60,000. In most non-qualified annuities, the IRS treats withdrawals as coming from gain first, which means that $60,000 gain is usually the first portion that becomes taxable when you withdraw.

This concept becomes clearer when you separate an annuity into two mental buckets: principal (your cost basis) and earnings (your gain). Your annuity account value is the combined total. Cost basis helps you estimate what portion of distributions may be taxable and what portion is simply the return of money you already paid taxes on.

Cost basis matters most in non-qualified annuities because those are funded with after-tax dollars. If your annuity is inside an IRA (or another qualified account), the “basis” concept works differently because qualified distributions are generally taxed as ordinary income. That’s why the first question we ask is always: is this a qualified annuity (inside an IRA) or a non-qualified annuity (outside an IRA)?

Qualified vs. Non-Qualified Annuities: Why This Changes Everything

A qualified annuity is an annuity held inside a tax-advantaged retirement account—most commonly an IRA or rollover IRA. Because qualified dollars have not been taxed yet (in the traditional IRA context), distributions are generally treated as ordinary income when withdrawn. In most cases, you do not track “cost basis” the same way in a qualified annuity because the entire distribution is taxable when it comes out (again, assuming pre-tax contributions and no special basis situation). That’s also why withdrawals from qualified annuities are often discussed in the same breath as RMDs and IRA distribution planning.

A non-qualified annuity is funded with after-tax dollars outside a retirement account. That’s where cost basis becomes a major factor. In a non-qualified annuity, only the gain portion is taxable, and cost basis helps you identify what part of the distribution is gain versus return of principal. This is also why non-qualified annuities are sometimes used in retirement income planning as a tax-managed income tool, depending on a household’s broader situation and goals.

If you’re still sorting through annuity types and how they behave, it can help to start with a broad overview here: Annuities. And if your focus is specifically guaranteed income planning, you may also like our pages on current annuity rates and retirement income structures.

How Cost Basis Changes Over Time

Your annuity cost basis is not always a single static number. It can change depending on what you do with the contract. If you make additional after-tax deposits into a flexible premium annuity, your cost basis generally increases by those deposits. If you take withdrawals, cost basis may decrease over time as principal is returned to you (depending on how distributions are taxed and tracked). If you take a withdrawal that is entirely taxable gain under LIFO rules, your basis may not decrease yet—because you haven’t received principal back, you’ve received earnings first.

Cost basis can also be affected by contract mechanics like partial annuitization, systematic withdrawal programs, or certain payout elections. It can also be affected by how older contracts were structured or reported. That’s why a “clean cost basis estimate” usually starts with the annuity’s premium history and the carrier’s tax reporting.

If you’ve ever looked at your annuity statement and wondered why the “earnings” number doesn’t match your expectations, it’s often because withdrawals, fees, or older reporting methods changed the relationship between the original premium and the current value. The key is not to guess. The key is to confirm what the carrier reports as cost basis and what the carrier reports as gain when you take distributions.

How Withdrawals Are Taxed in a Non-Qualified Annuity (LIFO Rules)

For most non-qualified annuities, withdrawals are taxed under LIFO rules—Last In, First Out. In practical terms, that means the IRS generally treats your withdrawal as coming from earnings first, and those earnings are taxable as ordinary income. Only after you have withdrawn all earnings does the IRS treat additional withdrawals as a tax-free return of your cost basis (principal). This is one of the biggest surprises for people who assume withdrawals are “pro-rata” (part gain, part principal). In most cases, they are not pro-rata for simple withdrawals. They are earnings-first.

This is why cost basis matters: it helps you estimate how much of your annuity is still earnings (taxable) versus principal (non-taxable). If you have a large gain sitting in the contract and you take a large withdrawal, you can trigger a larger-than-expected taxable event. And if you’re under age 59½, you may also face a 10% additional tax penalty on the taxable portion, depending on your situation and the nature of the distribution.

If liquidity and withdrawal flexibility are important to you, it can help to understand “free withdrawal” rules and contract limitations more broadly. Many contracts allow a percentage of the account value to be withdrawn annually without surrender charges. That’s contract-level liquidity, separate from tax treatment. Here’s a deeper resource on the contract side: Annuity Free Withdrawal Rules.

Annuitization and the Exclusion Ratio (Pro-Rata Taxation)

When you annuitize a non-qualified annuity—meaning you elect a formal payout option that converts the contract into a stream of payments—the taxation often changes from “earnings first” withdrawals to a more even, pro-rata style calculation called the exclusion ratio. The exclusion ratio is designed to determine what portion of each annuity payment is considered a tax-free return of principal (your cost basis) and what portion is taxable earnings.

Conceptually, this is how it works: the IRS takes your cost basis and spreads it across the expected payout period based on life expectancy tables and the payout option chosen. Each payment then has a taxable portion and a non-taxable portion until the cost basis has been fully recovered. After the basis is fully recovered, payments become fully taxable. The details are technical, but the planning implication is simple: annuitization can create more predictable tax treatment per payment compared with taking ad-hoc withdrawals under LIFO rules.

Many people compare annuitization against using an income rider. While both can create lifetime income, the mechanics and flexibility differ. If you’re exploring guaranteed income strategies, start with a broad overview of annuity structures and how income is generated: Annuities. And if you’re shopping for “safe-rate” options to support retirement income planning, use our current annuity rates page as a baseline reference.

Cost Basis and 1035 Exchanges

A 1035 exchange allows you to move value from one annuity to another annuity (or certain life insurance products) without triggering immediate taxation on the gain, as long as the exchange is done correctly. Cost basis becomes important here because the exchange typically carries your existing cost basis into the new contract. In other words, you do not “reset” your basis just because you moved carriers or products. You are transferring both the account value and the tax characteristics of the contract.

This is a common planning tool when someone has an older annuity with high fees, poor crediting options, or outdated features. A 1035 exchange can preserve tax deferral while improving the product fit. But you still need to understand where you stand on basis vs. gain, because future withdrawals from the new contract will still be affected by the carried-over gain. If you are considering an exchange as part of a retirement income plan, you’ll want to compare new contract options carefully and confirm surrender charges, rider costs, and income features before moving.

If you’re currently rate-shopping or considering repositioning from an older contract into a better structure, start by reviewing today’s marketplace snapshot here: Current Annuity Rates. Then use a structured review to compare what you have versus what’s available.

Cost Basis for Beneficiaries and Inherited Annuities

Cost basis questions also show up when an annuity owner dies and a beneficiary inherits the contract. Unlike many other assets, annuities do not typically receive a “step-up” in basis the same way many taxable investment accounts might. Instead, the general framework is that beneficiaries may owe ordinary income tax on the annuity’s gain when they receive distributions, while the cost basis portion is not taxed again because it represents after-tax principal.

The exact outcome depends on the type of annuity, the ownership and beneficiary structure, and the distribution option chosen. Some beneficiaries take a lump sum, some stretch distributions within allowed rules, and some continue the contract. The key takeaway is that cost basis still matters because it helps separate what portion is taxable gain versus return of principal.

When planning for beneficiaries, it can also help to understand annuity death benefit rules, beneficiary options, and timing considerations. See: Annuity Beneficiary Death Benefits.

Real-World Examples: How Annuity Cost Basis Works

Example 1: Simple non-qualified annuity withdrawal (earnings first). A retiree deposits $200,000 of after-tax money into a fixed annuity. Over time, it grows to $260,000. The cost basis is $200,000 and the gain is $60,000. If the retiree withdraws $30,000 as a lump sum, the IRS typically treats that $30,000 as coming from the gain first. That means the full $30,000 is generally taxable as ordinary income, and the remaining gain in the contract becomes $30,000. The cost basis is still $200,000 because principal has not been returned yet under earnings-first taxation.

Example 2: Multiple withdrawals that exhaust gains. Using the same contract, suppose the retiree withdraws another $40,000 the next year. The first $30,000 of that second withdrawal may be taxable gain (because $30,000 of gain remained), and then the remaining $10,000 would be treated as a return of principal and not taxable. At that point, the contract’s gain would be reduced to $0, and the cost basis would be reduced by the returned principal. Now the remaining account value would be entirely principal (assuming no new gains), and future withdrawals would generally be non-taxable until new gain accumulates.

Example 3: Annuitization and exclusion ratio concept. A policyowner has a non-qualified annuity with a $250,000 account value and a $200,000 cost basis. If they annuitize and receive structured payments, each payment may be part taxable and part non-taxable based on the exclusion ratio. Instead of “earnings first,” the tax treatment becomes more blended, which some retirees prefer for stable budgeting and predictable after-tax income. The trade-off is that annuitization can reduce flexibility compared to withdrawals or rider-based income designs.

Example 4: 1035 exchange carries basis forward. A policyowner has an older annuity worth $300,000 with a $220,000 cost basis (meaning $80,000 gain). They complete a 1035 exchange into a new annuity with improved features. After the exchange, the new contract value may still be $300,000 (minus any applicable transfer or surrender costs), but the cost basis remains $220,000. The owner did not erase the taxable gain; they preserved tax deferral while improving the contract. Future withdrawals will still be affected by that carried-over $80,000 gain.

Example 5: Beneficiary inherits an annuity. An owner dies with a non-qualified annuity worth $180,000 and a $140,000 cost basis. The contract has $40,000 of gain. If the beneficiary takes distributions, the beneficiary generally owes ordinary income tax on the gain portion, while the cost basis portion is not taxed again. The specific mechanics depend on how the beneficiary elects to receive funds, but the concept remains: cost basis is the “already-taxed money,” and gain is the “not-yet-taxed earnings.”  Learn more in our Inherited Non Qualified Annuity summary.

Common Mistakes with Annuity Cost Basis (and How to Avoid Them)

Mistake 1: Assuming withdrawals are pro-rata. For non-qualified annuities, many people assume each withdrawal is part principal and part gain. In most cases, it’s earnings first (LIFO). That can create unexpected taxable income if you take a large withdrawal while the contract has significant gain.

Mistake 2: Mixing qualified and non-qualified rules. An annuity inside an IRA behaves differently than an annuity outside an IRA. In qualified accounts, distributions are generally taxable as ordinary income (assuming pre-tax dollars). In non-qualified accounts, cost basis matters because only gain is taxable.

Mistake 3: Ignoring policy loans and older contract mechanics. Loans and older policy features can complicate net value and tax reporting. Always confirm what the carrier reports as cost basis and gain before making major moves.

Mistake 4: Treating “cost basis” as an accessible bucket. Cost basis is a tracking concept, not a separate pool of money you can withdraw from. Withdrawals are governed by contract rules and tax rules.

Mistake 5: Making a big withdrawal without mapping the tax result. If you’re using an annuity as a liquidity source, confirm the taxable portion before withdrawing. The best plans sequence withdrawals deliberately—especially when coordinating with Social Security, RMDs, and other income sources.

Cost basis is ultimately about avoiding surprises. If you know your basis and your gain, you can plan withdrawals more intentionally. You can decide whether smaller withdrawals over time make sense, whether annuitization creates a more stable after-tax income pattern, whether a 1035 exchange improves your long-term results without triggering immediate taxation, and how an annuity fits into the bigger picture of retirement income planning. In many households, the best strategy is not “one perfect move,” but a coordinated sequence of moves that improves cash flow, reduces volatility stress, and keeps taxes from derailing the plan.

If you’re actively making decisions right now—planning distributions, exchanging an older annuity, or coordinating income—start by mapping your contract values: current account value, reported cost basis, current gain, surrender schedule, and free withdrawal rules. Once those are clear, the best next step usually becomes obvious.