- Life & Money
- Financial Planning
- Your Retirement
How Is an Annuity Taxed?
- Daniel Schorn
- Apr 27, 2021

Many of the financial tools that you use for retirement have complicated tax rules. For instance, the money you put in 401(k)s, Roth accounts and non-qualified investment accounts will be taxed at some point — but how and when differs depending on the type of account, how long you’ve held your money in the account, and possibly even how much income you make.
Another tool often included in a diversified retirement plan is an annuity. Annuities, which can help you save for retirement or generate a guaranteed lifetime income after you retire, can protect you from the risk of outliving your assets.
But how is an annuity taxed? Understanding how they are taxed will help you get a clearer picture of how much money you’ll likely have in retirement. First, let’s review some annuity basics.
What is an annuity?
The different types of annuities fall into two main categories: ones that help you save for retirement over time, and ones that help you create income in retirement once you’ve paid a lump sum.
Annuities that help you save for retirement are known as accumulation annuities, and are designed to grow in value over time at either a fixed or variable rate. While fixed rate annuities grow in a dependable way, variable annuities give you the potential for exposure to market-based investments, which may increase or lose value based on what happens in the market. These annuities eventually give you the option to withdraw the money in the future and use it however you like, including converting it into an income stream once you retire
Generally, annuities that pay you a regular stream of periodic payments are known as income annuities and are often purchased in retirement or in the years leading up to it. How much income you can expect depends on a variety of factors, including how much money you paid for the annuity, when you purchased it and how long you’re expected to live after you start taking payments. Payments can either start soon after buying the income annuity, or you can defer the start of payouts to give your money time to grow during the deferral / accumulation period.
How is an annuity taxed?
First, a bit of good news: All annuities grow tax-deferred, meaning that you don’t have to pay any taxes until you take a distribution either through a regular payment or a withdrawal from an accumulation annuity. Unlike non-qualified investment accounts or savings accounts that are subject to annual taxation, the growth in an annuity can compound undisturbed and thus may grow more over time.
While the money in an annuity will grow tax-deferred, once you start withdrawing your money, that growth will be taxed as ordinary income.
But what about the money you paid into your annuity? The way this money is taxed depends on how you fund the annuity. There are two types of annuity accounts, qualified and non-qualified.
- Qualified annuities are those purchased through a qualified plan like a 401(k) or SIMPLE IRA, and are normally paid for with pre-tax dollars. In this case, the tax rules governing qualified plans and IRAs essentially trump the annuity tax rules, which generally means that the full annuity payout is taxed as ordinary income.
- Non-qualified annuities are funded with money that has already been taxed. And because the money you put in was already taxed, only the growth portion of your annuity is subject to taxation. The principal (or basis) — the money you put in — will be returned to you tax-free, while the earnings growth will be taxed as ordinary income.
But how does the IRS determine what portion of your payout will be taxed? The answer to this depends on whether payments are being made from an income annuity or from an accumulation annuity.
RELATED CONTENT: What is an annuity? Our guide to annuities can help you learn more about the unique role an annuity can play in your retirement planning.
How are distributions from accumulation annuities taxed?
With accumulation annuities, how you funded the annuity again comes into play.
For non-qualified annuities: You won’t owe tax on the amount you paid into the annuity. But you will owe ordinary income tax on the growth. And when you make a withdrawal, the IRS requires that you take the growth first — meaning you will owe income tax on withdrawals until you have taken all the growth. Once the growth portion has been exhausted, you’ll start receiving funds tax-free from the principal, or basis.
One way to get around this is to convert your accumulation annuity into an income stream, a process called “annuitization.” Once you’ve annuitized your former accumulation annuity, the income stream going forward is taxed based on the exclusion ratio.
For qualified annuities: Again, the tax rules for qualified plans and IRAs trump the rules for the annuity. If all contributions were made pre-tax, as they usually are in this context, then you will owe ordinary income tax on any withdrawal or distribution.
For both types of annuities: The IRS considers annuities retirement vehicles, and as a result an early withdrawal or distribution could trigger a tax penalty. If the owner of the account or contract is younger than 59½ years old and withdraws funds from an annuity, the taxable portion of the payout could be hit by a 10 percent tax penalty.
Per the IRS, there are several situations that won’t trigger the penalty, including taking a distribution if the owner dies or becomes disabled, and it also normally does not apply if an income annuity is paid for life.
How are distributions from income annuities taxed?
The taxation of income annuities is based on something called the “exclusion ratio.” It’s a calculation that factors in how much you paid into the annuity, how much it has earned, and how long payments will last (which generally is your life expectancy if it is a life-based income annuity.
Let’s imagine this scenario: You have an income annuity and have a life expectancy of 90. The regular payouts are structured to spread out the principal and earnings until you’re 90. The principal portion of your payment is tax-free and divided equally among your expected payments, while the earnings portion is taxed as ordinary income. But say you live to age 95. During those “extra” five years, your full payouts will be taxed as ordinary income, given that the principal has been exhausted.
It’s a good idea to work with your financial and tax advisors before taking a withdrawal from an annuity to understand how your taxes and your retirement income could be impacted.
Withdrawals are pursuant to possible contract limitations/adjustments and IRS tax rules.
Annuities are contracts sold by life insurance companies and are considered long-term investments that may be suitable for retirement. Income annuities (either immediate or deferred) have no cash value and once issued they can’t be terminated (surrendered). The original premium paid is not refundable and cannot be withdrawn.
All guarantees associated with annuities and income plans are backed solely by the claims-paying ability of the issuer.
All investments carry some level of risk, including potential loss of principal. Withdrawals from variable annuities may be subject to ordinary income tax, a 10% IRS penalty if taken before age 59 ½, and contractual withdrawal charges.
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