Important: This entire page is general educational information only and does not constitute tax advice. Annuity taxation is complex and varies by individual circumstance, state of residence, and contract type. Consult a qualified tax professional before making any decisions based on tax considerations.
The Two Questions That Determine How Your Annuity Is Taxed
Every annuity tax question comes down to two things:
Question 1: Is it qualified or non-qualified?
A qualified annuity is purchased with pre-tax money inside a retirement account (IRA, 401(k), 403(b), etc.). Since the money was never taxed going in, every dollar coming out is fully taxable as ordinary income.
A non-qualified annuity is purchased with after-tax money (regular savings). Since you already paid tax on the premium, only the earnings are taxable. Your original investment is returned tax-free.
Question 2: Are you in the accumulation phase or the distribution phase?
During accumulation (the money is growing inside the annuity), there are no taxes due — regardless of whether the annuity is qualified or non-qualified. All growth is tax-deferred.
During distribution (you are taking money out), taxes apply — and the rules depend on whether it is qualified or non-qualified, and whether you are taking random withdrawals or receiving income payments.
Annuity Tax Rules: Master Reference Table
Tax Event | Qualified (IRA/401k) | Non-Qualified (After-Tax) |
|---|---|---|
During accumulation (growth phase) | No tax. Tax-deferred. | No tax. Tax-deferred. |
Withdrawals from deferred annuity | 100% taxable as ordinary income | LIFO: Earnings taxed first as ordinary income. After all earnings withdrawn, remaining is tax-free return of basis. |
Income payments (SPIA/DIA) | 100% taxable as ordinary income | Exclusion ratio: Each payment split into tax-free return of principal + taxable earnings. After full basis recovered, all payments fully taxable. |
Before age 59½ | 10% IRS penalty on taxable amount + income tax | 10% IRS penalty on taxable amount (earnings) + income tax |
After age 59½ | Ordinary income tax only (no penalty) | Ordinary income tax on earnings only (no penalty) |
Required Minimum Distributions (RMDs) | Yes — begins at age 73 (75 starting 2033) | No — no RMDs (unless inherited) |
1035 Exchange | Tax-free (qualified → qualified only) | Tax-free (non-qualified → non-qualified only) |
Death benefit to spouse | Spouse can continue contract or roll to own IRA (tax-deferred) | Spouse can continue contract (tax-deferred) or take lump sum (taxable on gains) |
Death benefit to non-spouse | 100% taxable. Must distribute within 10 years (SECURE Act). | Gains taxable as ordinary income. Must distribute within 10 years or as life expectancy payments. |
Step-up in cost basis at death | N/A (all proceeds taxable regardless) | No. Unlike stocks/mutual funds, annuities do NOT receive a step-up. Embedded gains remain taxable to beneficiary. |
Non-Qualified Annuity Taxation in Detail
Withdrawals from deferred annuities: LIFO rules
When you withdraw from a non-qualified deferred annuity (MYGA, FIA, VA), the IRS uses Last-In, First-Out ordering. Earnings are deemed to come out first:
Example: You invested $100,000 in a MYGA. It has grown to $130,000. You withdraw $20,000.
LIFO result: The first $30,000 of any withdrawal is considered earnings (taxable). Since your $20,000 withdrawal is less than the $30,000 in gains, the entire $20,000 is taxable as ordinary income. Your cost basis remains $100,000; the remaining contract value is $110,000 with $10,000 in unrealized gains.
Income payments: The exclusion ratio
When you annuitize a non-qualified annuity (receive SPIA or DIA payments), the exclusion ratio determines how much of each payment is tax-free:
Exclusion Ratio = Investment in Contract ÷ Expected Total Payments
Exclusion Ratio = Investment in Contract ÷ Expected Total Payments
Example: You invest $200,000 in a SPIA. Based on life expectancy, the insurer expects to pay you $320,000 total.
Exclusion ratio: $200,000 ÷ $320,000 = 62.5%
Each $1,500 monthly payment: $937.50 is tax-free (62.5% × $1,500) and $562.50 is taxable (37.5% × $1,500).
After you receive $320,000 total: Your full $200,000 investment has been recovered. All subsequent payments are 100% taxable.
The exclusion ratio is calculated once at the start of income and does not change. If you outlive the expected period (meaning the insurer pays more than expected), the extra payments are fully taxable. This is a tax cost of longevity — but you are still receiving guaranteed income for life, which is the larger benefit.
Qualified Annuity Taxation in Detail
Qualified annuities are simpler: everything is taxable. Since premiums were contributed with pre-tax money, no portion has ever been taxed. Every dollar withdrawn or received as income is ordinary income.
RMD implications
Qualified annuities are subject to required minimum distributions beginning at age 73 (rising to 75 in 2033). The annuity value is included in the RMD calculation for the account type that holds it. If the annuity is inside a Traditional IRA, its value is part of your total IRA balance for RMD purposes.
Exception: QLACs (Qualified Longevity Annuity Contracts) are excluded from the RMD calculation, up to $200,000. See our QLAC guide for details.
Once a qualified annuity is annuitized (converted to income payments), the payments themselves satisfy the RMD requirement for the amount held in that annuity. You do not need to take a separate RMD from the annuity in addition to receiving its income payments.
Tax Treatment by Annuity Type
Annuity Type | Phase | Non-Qualified Tax | Qualified Tax |
|---|---|---|---|
MYGA | Growth | Tax-deferred | Tax-deferred |
Withdrawal | LIFO (earnings first) | 100% taxable | |
FIA | Growth | Tax-deferred | Tax-deferred |
Withdrawal / GLWB income | LIFO (earnings first) | 100% taxable | |
SPIA | Income payments | Exclusion ratio | 100% taxable |
DIA | Deferral period | No tax | No tax |
Income payments | Exclusion ratio | 100% taxable | |
QLAC | Deferral period | N/A (qualified only) | No tax + RMD exempt |
Income payments | N/A | 100% taxable | |
Variable Annuity | Growth | Tax-deferred | Tax-deferred |
Withdrawal | LIFO (earnings first) | 100% taxable |
Special Tax Situations
The 59½ penalty
The IRS imposes a 10% penalty on the taxable portion of annuity withdrawals taken before age 59½. This is in addition to ordinary income tax. Exceptions exist for death, disability, substantially equal periodic payments (SEPP/72(t)), and certain immediate annuity payments structured as a series of substantially equal payments.
Death benefits and inheritance
Unlike stocks and mutual funds, annuities do not receive a step-up in cost basis at the owner’s death. This means embedded gains in a non-qualified annuity are taxable to the beneficiary. Spousal beneficiaries may continue the contract (maintaining tax deferral). Non-spousal beneficiaries must generally distribute within 10 years under the SECURE Act, with all gains taxable as ordinary income.
This no-step-up rule is a significant disadvantage for estate planning. If you hold both annuities and taxable investments, consider spending the annuity during your lifetime and leaving the taxable investments (which do get a step-up) to heirs.
1035 exchanges
A 1035 exchange transfers one annuity to another tax-free. Cost basis carries over. No taxes are due at the time of exchange. See our complete 1035 exchange guide.
Annuitization vs. withdrawal
For non-qualified annuities, the tax treatment differs based on how you take money out. Withdrawals use LIFO (earnings first, fully taxable). Annuitization (converting to income payments via a SPIA or DIA) uses the exclusion ratio, which spreads the tax more evenly across payments. For someone with significant gains in a non-qualified annuity, annuitization can produce a more favorable tax outcome than systematic withdrawals.