Are Annuities Taxable? A Clear Guide to How Annuity Taxes Work
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Andrew Lisa
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Emily Gadd, CCC™
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If you own an annuity — or you’re thinking about buying one — you’re probably wondering how much of it the IRS will tax. The answer isn’t one-size-fits-all. Whether annuities are taxable, and how much tax you’ll owe, depends on how the annuity was funded, how you take money out and when you start withdrawals.
The good news is that annuities offer tax deferral, meaning you don’t pay taxes while your money grows. The trade-off is that taxes usually apply when you take money out, and they’re typically taxed as ordinary income rather than capital gains. Understanding these rules ahead of time can help you avoid surprises and decide whether an annuity makes sense for your retirement plan.
The Internal Revenue Service confirms that annuities are generally taxed when distributions occur, not while funds remain in the contract.
Quick Answer: How Annuities Are Taxed
If you want the short version, here it is:
- Annuity earnings are taxed as ordinary income, not capital gains
- Qualified annuities (funded with pre-tax money) are usually fully taxable
- Non-qualified annuities (funded with after-tax money) tax only the earnings
- No taxes are due while money stays in the annuity
- Withdrawals before age 59½ may trigger a 10% additional tax
These rules apply regardless of whether your annuity is fixed, indexed or variable.
Annuity Taxation At a Glance
| Annuity Type | How it’s funded | What’s taxable | When taxes apply | Possible penalty |
|---|---|---|---|---|
| Qualified annuity | Pre-tax dollars (IRA or 401(k)) | Most or all withdrawals | When distributed | 10% before 59½ |
| Non-qualified annuity | After-tax dollars | Earnings only | When withdrawn | 10% on earnings before 59½ |
| Roth-funded annuity | Roth dollars | Often tax-free | If rules met | Rare |
| Inherited annuity | Depends on contract | Earnings portion | Depends on the contract | No 10% penalty |
Why Annuities Are Taxed This Way
Annuities are designed to provide retirement income, not short-term investment gains. Because of that, the tax code allows your money to grow without annual taxes and then applies taxes when income begins.
The IRS classifies annuity payments as retirement income, which is why distributions are generally taxed as ordinary income rather than capital gains.
This structure can be helpful if you expect to be in a lower tax bracket later, but it can also concentrate taxes into retirement years if withdrawals aren’t planned carefully.
How Qualified Annuities Are Taxed
A qualified annuity is purchased with pre-tax dollars, typically inside a traditional IRA or 401(k).
Because you never paid taxes on the money going in:
- Most withdrawals are fully taxable
- Taxes are owed at ordinary income tax rates
- Required minimum distribution rules may apply
From a tax standpoint, the IRS treats qualified annuity distributions the same way it treats other pre-tax retirement income.
How Non-Qualified Annuities Are Taxed
A non-qualified annuity is funded with money you’ve already paid taxes on.
Here’s how that affects you:
- Your original investment is not taxed again
- Only the earnings portion is taxable
- Taxes apply when money is withdrawn
This distinction matters. Two people can withdraw the same amount from an annuity and owe very different taxes depending on how the annuity was funded.
Withdrawals vs. Income Payments: Two Tax Methods
How you access annuity money determines how taxes are calculated.
Deferred Annuity Withdrawals (LIFO Rule)
Withdrawals from deferred annuities follow last-in, first-out (LIFO) rules:
- Earnings come out first
- Earnings are fully taxable
- Principal comes out later and is tax-free
The IRS applies LIFO treatment to withdrawals from non-qualified deferred annuities.
Annuitized Income Payments (Exclusion Ratio)
If you convert an annuity into a regular income stream:
- Each payment is split between taxable earnings and tax-free principal
- The split is calculated using an exclusion ratio
- Taxes are spread out over your expected payout period
The IRS explains how exclusion ratios apply to annuitized contracts.
Simple Annuity Tax Example
Non-Qualified Deferred Annuity
- Investment: $100,000
- Account value: $130,000
- Earnings: $30,000
- Withdrawal: $20,000
Tax Result
- $20,000 taxable
- $0 tax-free
Because earnings come out first under LIFO rules, the entire withdrawal is taxable.
Are Annuities Taxed as Capital Gains?
No. Annuity earnings are taxed as ordinary income, even if the annuity invests in stocks or bonds.
The IRS does not allow capital gains tax treatment for annuity distributions.
Early Withdrawals and the 59½ Rule
If you withdraw taxable amounts from an annuity before age 59½, you may owe:
- Ordinary income tax
- Plus a 10% additional federal tax
This penalty applies to both qualified and non-qualified annuities and is in addition to regular income tax. Inherited annuities are generally exempt from this penalty.
What Tax Forms Report Annuity Income?
Most annuity distributions are reported on IRS Form 1099-R.
This form shows:
- Total distributions
- Taxable amount
- Any federal income tax withheld
The IRS uses Form 1099-R to match annuity income with your tax return.
Are Inherited Annuities Taxable?
Inherited annuities usually do not receive a step-up in basis.
In most cases:
- Beneficiaries owe tax on the earnings portion
- The 10% early-withdrawal penalty does not apply
- Taxes depend on payout timing
The IRS outlines how beneficiary annuity payments are taxed.
Should You Own an Annuity? A Tax-Focused Decision Guide
Annuities work best as income tools, not growth vehicles.
An Annuity May Make Sense If You:
- Want predictable lifetime income
- Are concerned about outliving savings
- Have already maxed out IRAs and 401(k)s
An Annuity May Be a Poor Fit If You:
- Expect to be in a high tax bracket later
- Prefer capital gains tax treatment
- Need access to money before age 59½
The IRS notes that annuities require careful planning because of their tax structure and distribution rules.
Final Take to GO
Are annuities taxable? Yes — but the details matter. Qualified annuities are usually fully taxable, non-qualified annuities tax only earnings and early withdrawals can trigger penalties. By understanding how annuity taxes work before you buy or withdraw, you can decide whether an annuity fits your retirement plan — and avoid costly surprises later.
Are Annuities Taxable? FAQ
- Are annuities taxed while they grow?
- No. Taxes are deferred while money stays in the annuity and apply only when funds are withdrawn.
- Are annuities taxed as ordinary income?
- Yes. Annuity earnings are taxed as ordinary income, not capital gains.
- Is there a penalty for cashing out an annuity early?
- Yes. Taxable withdrawals before age 59½ may face a 10% additional federal tax.
- What tax form reports annuity income?
- Annuity income is reported on IRS Form 1099-R.
- Will beneficiaries owe tax on inherited annuities?
- Usually yes. Beneficiaries are taxed on the earnings portion of inherited annuities.
Jacob Wade contributed to the reporting of this article.
Information on promotions is accurate as of Jan. 13, 2026.
