How Are Annuities Taxed?

If you buy an annuity using a 401(k), IRA or other pre-taxed money, payouts from the insurance company are fully taxable as income. If you buy an annuity with cash, savings or other after-tax funds, only the interest and earnings from payouts are taxable.

How Are Annuities Taxed?

Annuities are tax deferred. This means you won’t owe taxes until you receive payouts from the insurance company, or you withdraw funds from your account.

There are two tax scenarios for annuity payouts:
  1. Qualified
  2. Nonqualified

A qualified annuity is usually purchased using a 401(k), Individual Retirement Account (IRA) or similar source of pre-taxed money.

Qualified annuity payouts are fully taxable as income.

In the eyes of the Internal Revenue Service, you avoided taxes when you first purchased your annuity using a 401(k) or IRA, so you’ll owe money on the backend when you start receiving payouts.

The second scenario is a nonqualified annuity. This means taxes were already taken out when you bought your annuity using cash or savings.

Nonqualified annuities offer less tax bite on the backend. Only interest and earnings are taxable, not the entire payout.

Unlike growth from stocks or mutual funds, nonqualified annuity gains are taxed as ordinary income, not capital gains.

Just a portion of your nonqualified payouts come from interest and earnings. Mostly, it’s a return of your principal — the lump sum you used to first purchase your annuity.

An exclusion ratio tells you what percentage comes from gains — and is therefore taxable — and how much is simply your own principal coming back to you.

Your insurance company will provide you with your contract’s monthly exclusion ratio.

If You Outlive Your Life Expectancy

Many annuities guarantee a fixed income stream for life. This is what makes them so appealing to retirees.

However, when you purchase this type of annuity, the insurance company takes your life expectancy into consideration.

For example, imagine you purchase a $100,000 annuity at age 65 and have a life expectancy of 85. The insurer spreads your principal investment over 20 years. You’re likely to collect some interest and earnings along the way, too.

Even if you live past 85, you’ll keep getting regular payouts from the insurance company. But your tax burden will suddenly increase.

Any annuity payments received after your actuarial life expectancy are fully taxable as income.

That’s because once your principal is returned to you, any additional payouts or withdrawals are counted as earnings. You’ll pay ordinary income tax on the entire amount.

How Are Withdrawals Taxed?

Different tax rules may apply when you withdraw money from your annuity account.

First, if you withdraw funds before the age of 59.5, you’ll incur a 10 percent tax penalty. The IRS does something similar if you take early withdrawals from your 401(k) or IRA.

If you make a withdrawal and you’re older than 59.5, you avoid the 10 percent penalty. But you will still owe income tax on interest and earnings.

This is where things can get tricky.

When you withdraw money — unlike when you receive regularly scheduled payouts —something called the last-in-first-out tax rule applies.

Basically, your first withdrawal is front loaded with all the gains and interest you’ve accumulated in your account. Your first payment may be fully taxable as income.

For example, imagine you purchase a deferred annuity for $100,000. Over 20 years, you earn an additional $30,000 through interest and earnings.

Now, you want to withdraw $20,000. That withdrawal comes exclusively from the $30,000 of new money — and is fully taxable as income. Unfortunately, the IRS won’t let you withdraw from the $100,000 of principal first, which would spare you from taxation.

However, maybe you want to withdraw $20,000 after 10 years. At that point, you’ve only earned $10,000 in interest and gains. You’re required to tap the $10,000 in new money first — and pay taxes on it — but the other $10,000 comes from your principal and avoids taxes.

Inherited Annuity Taxation

If you inherit an annuity, you need to find out if it’s qualified or nonqualified. As discussed earlier, qualified annuity payouts are taxed as ordinary income while nonqualified annuity payouts are only taxed on interest and earnings.

Your relationship to the deceased owner also matters.

For example, a surviving spouse can transfer the annuity contract into his or her own name. According to the Internal Revenue Service, this allows spouses to enjoy the tax-free portion of annuity payouts the same way as the original owner.

Spouses may also choose to simply receive the annuity death benefit instead.

Ways Beneficiaries Can Receive Inherited Annuity Money
  • A one-time lump sum payout
  • Payouts over five years
  • Payouts over the beneficiary's life expectancy

A one-time lump sum carries a big tax bite. You’ll owe taxes on the entire difference between what the owner paid for the annuity and the death benefit. That includes any interests or gains within the account.

Taking a lump sum can also push you into a higher tax bracket and result in an even bigger tax bill.

Stretching payments over five years softens the tax blow. You’ll only owe taxes on the annuity’s increased value of the portion withdrawn that year instead of getting taxed on all interest and earnings at once.

Finally, some annuity contracts allow beneficiaries to spread payments out over their lifetime. This offers the least tax exposure but will take the longest time to receive all the money.

Last Modified: September 11, 2020

7 Cited Research Articles

  1. Internal Revenue Service. (2020, August 10). Topic Number 410 – Pensions and Annuities. Retrieved from https://www.irs.gov/taxtopics/tc410
  2. Internal Revenue Service. (2020, February 12). Publication 575 Pension and Annuity Income. Retrieved from https://www.irs.gov/publications/p575#en_US_2016_publink1000226982
  3. Internal Revenue Service. (2020, January 8). Retirement Topics - Beneficiary. Retrieved from https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-beneficiary
  4. Parrish, S. (2019, December 19). The ‘Gotchas’ In Annuity Taxation. Retrieved from https://www.forbes.com/sites/steveparrish/2019/12/18/the-gotchas-in-annuity-taxation/#6a8273076ae8
  5. Sahadi, J. (2018, May 11). Before choosing an annuity, know the tax implications. Retrieved from https://money.cnn.com/2018/05/11/pf/taxes/annuities-taxes/index.html
  6. Alabama Department of Insurance. (n.d.). Annuities: How About Taxes? Retrieved from https://www.aldoi.gov/Consumers/AnnuityTaxes.aspx
  7. Florida Department of Financial Services. (n.d.). Annuity Overview: Tax Treatment. Retrieved from https://www.myfloridacfo.com/Division/Consumers/understandingCoverage/AnnuityOverview.htm