Published: March 23, 2021

Updated: December 30, 2025

How Are Annuities Taxed? The Essential Guide for Retirees

Annuities are tax-deferred while they grow. When money comes out, earnings are taxed as ordinary income. Whether your principal is taxed depends on how the annuity was funded (qualified vs non-qualified).

Annuities can be taxable, based on whether they are qualified or non-qualified. Qualified annuities, funded with pre-tax money, are taxable upon withdrawal or receiving income. Non-qualified annuities, funded with after-tax money, only tax the earnings portion when you withdraw or start receiving payments.

Annuities offer tax-deferred growth. Tax deferral provides a significant advantage for two reasons:

First, it means that you can defer income tax on annuity gains until retirement. Most retirees have lower incomes and are in a lower tax bracket in retirement than when they were working. So, deferring your taxes into retirement usually means you pay less in taxes overall.

Second, the tax deferral means you earn interest on the money that would otherwise be going to taxes each year. That money works for you before you have to hand it over to the IRS.

But while they provide substantial tax benefits, annuities are not tax-free. What taxes will you pay? And how much will they be? Let’s break it down for you.

Are Annuities Tax-Free?

Are annuities tax-free? Not quite. Annuities are tax-deferred. That means you don’t pay taxes on the funds while they grow. Instead, you pay taxes later when you receive the funds.

When you do pay taxes, your annuity income is taxed as regular income. This means that the tax rate depends on how much income you earned and which tax bracket you fall into the year you receive your funds.

That's different from investment products like mutual funds, which are taxed as capital gains. Depending on your income, your federal income tax rate could be higher than the capital gains rate.

What tax rate applies to annuity income?

At the federal level, annuity earnings are taxed at ordinary income rates based on your total taxable income for the year you receive payments. State income tax may also apply. High-income households may owe the 3.8% Net Investment Income Tax on certain taxable annuity gains. Always confirm your current bracket and state rules before taking withdrawals.

Breaking Down the Taxation Differences in Qualified and Non-Qualified Annuities

The way that any given annuity is taxed depends on the money used to set it up. If you used pre-tax dollars to fund your initial deposit, it's a qualified annuity. If you set up your annuity with money you already paid taxes on, it's a non-qualified annuity. Whether you have a qualified annuity or a non-qualified annuity is key to determining how your annuity is taxed.

How Qualified Annuities Are Taxed

You fund a qualified annuity with pre-tax money (money you have yet to pay taxes on). Funds for a qualified annuity typically come directly from a 401(k), a Roth IRA, or other tax-deferred individual retirement account.

Once the money is in the account, it continues to grow tax-deferred. This means that both the principal and the earnings have not been taxed yet. Eventually, your annuity will enter the payout phase, and the money will be paid back to you (either in periodic payments or as a lump sum).

When that happens, you will pay taxes on the distributions.

How Non-Qualified Annuities Are Taxed

Non-qualified annuities work a bit differently because they're funded with after-tax dollars (money you've already paid taxes on). It can help to think about your non-qualified annuity as having two parts:

• The principal (funded with after-tax dollars)
• The earnings (annuity growth from interest, dividends, or capital gains)

Since you’ve already paid taxes on the principal, you don’t have to pay taxes on it again. Your principal won’t be taxed. However, you’ve yet to pay taxes on your earnings. So when you receive distributions, you must pay taxes on any gains.

Non-Qualified Annuities Are Taxed Using an Exclusion Ratio

So, now you know you pay taxes on the gains from a non-qualified annuity withdrawal. But how do you figure out which part of the distribution represents gains and which is principal? It’s determined using an exclusion ratio. An exclusion ratio is a number that tells you the portion of your annuity payment that comes from after-tax dollars.

This amount is excluded from tax payments. That leaves you to pay taxes only on what you’ve earned while the annuity was growing.

Taxation Depends on How You’re Paid Out

How you receive payouts can also change the tax structure of a non-qualified annuity.

Most annuitants opt to have their annuity paid back to them in periodic payments over their lifetime.

In that case, the taxable portion is calculated then each payment gets prorated over their expected lifetime. If you choose this route and outlive the life expectancy, all additional payments are subject to ordinary income taxes.

If you take your payout in a lump sum, it’s a bit different. Lump-sum payments are taxed using the last in, first out (LIFO) rule.

This means that the most recent money to enter the annuity is the first money withdrawn. For example, imagine you bought an annuity for $100,000. It grew, and now it's worth $200,000. That means that half of your $200,000 annuity is principal and half is earnings.

Now, imagine you want to take out a lump sum of $100,000. Under the LIFO rule, the $100,000 you withdraw is taxed as gains and the remainder left in the annuity represents the principal. And because it’s all considered earnings, all of it is taxable.

So, you would pay taxes on that entire first withdrawal. But the remaining withdrawals would come from your principal and be tax-free.

Keep in mind that large lump sum withdrawals count towards your annual income and may push you into a higher tax bracket.

All that is to say: How you withdraw from your non-qualified annuity has significant tax implications.

State taxes and “10 year annuity” questions

States generally tax annuity earnings as ordinary income when they are paid out. A 10-year annuity term does not create a special state tax by itself. Your state may exempt some retirement income or have no income tax at all (for example, FL, TX, NV, WA, SD). Check your state revenue site for details.

How Do Early Withdrawals Affect Taxes on Annuities?

What if you want to withdraw from your annuity early? The goal of a deferred annuity is to help you plan for retirement. You save money now to provide you with retirement income later. If you want to withdraw money early, you’re likely going to face several types of fees. If you withdraw money before 59 ½, the IRS may charge you a 10% tax penalty on gains. However, this depends on the type of annuity you have.

There are also some exceptions for special circumstances (for example, if you are totally and permanently disabled). If you withdraw early, you will also still pay the normal income tax rate on the taxable amount.

Remember, the entire withdrawal is taxable if you have a qualified annuity. But only the earnings are taxable if you have a non-qualified annuity. On top of that, you may also pay early withdrawal fees to the insurance company. In an annuity, early withdrawal fees are called surrender charges.

Annuities have a surrender period, during which you must pay a fee for taking withdrawals. The annuity contract lists the surrender period, and the annuity agent should disclose the surrender charge schedule before you buy. Some annuities allow for a percentage of the account value or the interest to be withdrawn without paying a penalty (this is called a penalty-free withdrawal).

If you think you might need to withdraw money from your annuity during the surrender charge period, make sure the amount of the penalty-free withdrawal is sufficient so you don’t incur surrender charges.

Between early withdrawal penalties and other annuity fees, it can be quite expensive to withdraw from your annuity early. But remember that different annuity contracts have different fees. Some products, like the Flex Fund offered by Canvas, offer a lot of flexibility, even allowing you to cancel your contract at any time and receive your full premium back, less any prior withdrawals.

Inherited Annuity Taxation

What about if you pass away and your annuity is inherited by your beneficiary—will they have to pay taxes on an inherited annuity? The rules for a beneficiary are the same as the rules for the policyholder. If it’s a qualified annuity, they must pay taxes on the entire distribution. If it’s a non-qualified annuity inheritance, they owe taxes on the earnings but not the principal.

Again, annuity withdrawals are taxed at the ordinary income tax rate, not at the capital gains rate. And the beneficiary doesn't owe taxes until they withdraw the funds. But who the beneficiary is, determines exactly how the annuity's taxes work.

Spousal Death Benefits

There are some special rules for spousal beneficiaries. Spouses have the option to roll the annuity over in their name. This is called spousal continuation and when this happens, the annuity carries on as if the surviving spouse were the original policyholder.

All of the same tax rules apply, and the spouse owes taxes when they withdraw funds.

Rules for Non-spouse Beneficiaries

For non-spouse beneficiaries of qualified annuities, taxes depend on the payout structure that the beneficiary selects. If the beneficiary selects a lump sum payment, they must pay taxes immediately at the time of receipt.

Keep in mind that large lump sums can significantly increase yearly earnings, and that may push the taxpayer into a higher tax bracket for that year, resulting in a higher tax rate. To avoid being bumped into a much higher tax bracket, the beneficiary can select a periodic or monthly payment schedule. Taxes will be owed as the payments occur. Spreading out the distributions avoids massive income gains for any given year.

This also lets the beneficiary only pay taxes on a portion of the annuity each year. If the annuity is not held within an IRA, you have 5 years to withdraw the annuity. If the annuity is held in an IRA, the Federal SECURE Act dictates that the designated beneficiary must withdraw the entire annuity amount once they've had the annuity for 10 years.

There are some exceptions to the 10-year rule, such as for disabled beneficiaries, chronically ill beneficiaries, individuals who are not more than 10 years younger than the decedent, and minor children of the plan participant. Also, because this rule is fairly new, some older annuities are grandfathered into previous rules. Talk to a tax advisor for more specific details on tax rules of inherited annuities, especially if the annuity was purchased in 2019 or earlier.

More Annuity Taxation Rules You Should Know

Depending on your situation, several other tax rules may apply to you. The following are some of the more common additional tax rules.

The “No Natural Person” Rule

Annuities grow tax-deferred each year for individuals but not corporations. For corporations or irrevocable trusts, growth is taxable each year.

One exception is a trust annuity held for an individual annuitant's benefit; these are given tax-deferred treatment like typical annuities. If you'd like to make the owner of your annuity a trust, consult a tax advisor for more details. (For more information, read our guide on annuity trusts and how they work)

Borrowing Against the Annuity

Some annuity contracts let you borrow against your annuity.

If you borrow against it, the loan is usually considered a withdrawal and is taxed as a lump sum withdrawal. But keep in mind that you cannot borrow against all annuities. For example, the annuity products offered by Canvas do not allow loans. Be sure to check with your individual annuity contract to determine if you can borrow against it.

Gifting Annuities

You may gift your annuity to someone else.

However, you would have to pay income tax on any gains in the annuity before gifting it. Likewise, if you receive an annuity as a gift, the donor would have to pay taxes on it before gifting it to you (typically a gift is completed by initiating a change owner which is why it is a taxable event).

Required Minimum Distributions (RMDs)

SECURE 2.0 changed the starting age for RMDs to 73 for most people, and to 75 starting in 2033. If you have a qualified annuity, you must take RMDs once you reach your applicable age or you could face IRS penalties.

Annuity Taxation: The Takeaway

Annuities offer a powerful way to secure a guaranteed income stream in retirement and to defer paying taxes. That makes them ideal for retirement planning. Many retirees use annuities to supplement their social security payments or other retirement income. But it’s important to understand how and when they will be taxed.

How an annuity is taxed depends largely on the funds used for its principal deposit.

You should only ever pay taxes on the same dollar once. If your annuity's principal comes from money that’s already been taxed, you don’t have to pay taxes on it again. But if it comes from pre-taxed money, you do. In either case, you will have to pay taxes on all earnings.

But it’s important to understand how and when annuity taxation occurs. How an annuity is taxed depends largely on how you bought it. When it was purchased with money that’s already been taxed, you don’t have to pay taxes on that money again. But if it comes from pre-taxed money, it is taxable.

Annuity taxation rules are generally favorable, but whether an annuity is the right financial product for you depends on your particular circumstances.

And remember, tax rules change. Make sure to speak to a tax professional to get specific advice about your particular circumstances in order to avoid a weighty tax bill. Are you interested in taking advantage of the tax benefits a fixed annuity can offer? Get in touch with the non-commissioned agents at Canvas!

They can help you learn more about what an annuity can do for your retirement plan, and how it can help you secure your financial future. Start today!

FAQ

Do annuities get taxed?

Yes. Earnings are taxed as ordinary income when paid out. For qualified annuities, the entire distribution is taxable. For non-qualified annuities, only earnings are taxable.

What rate are annuity payments taxed at?

They are taxed at your ordinary income rate for the year you receive them. State income tax may also apply.

Are Roth annuity payouts taxed?

Qualified Roth distributions are generally federal income tax-free. Confirm 5-year and age rules with your tax advisor.

Citations

1. Ehling, E. H. Jr. & Marmon, R. (2020, March 25). The Impact of the SECURE Act on Qualified and Non-Qualified Annuities. New Jersey Law Journal. Retrieved March 3, 2021.

2. US Government (2019). Setting Every Community Up for Retirement Enhancement (SECURE) Act. Congress.gov. Retrieved March 3, 2021.

3. Parthemer, M. R. & Klein, S. (2020). The SECURE Act Top Ten. Retrieved March 18, 2021.