How Are Annuities Taxed? A Complete Guide

This article is for general informational purposes only and does not constitute tax, legal, or financial advice. The information provided may not apply to your individual circumstances and should not be used as the basis for any specific tax decision. Tax laws are subject to change. Please consult a qualified tax professional regarding your personal tax situation.

Understanding how your retirement income is treated by the IRS is essential for protecting your long-term financial health. Annuities are taxable, but the specific amount you pay depends on the type of annuity you own and when you choose to take withdrawals. Unlike many other investments, annuities benefit from tax-deferred growth, meaning you do not pay taxes on the interest or earnings while the money stays inside the contract. Instead, you only owe taxes when you start receiving income or take a distribution, allowing your principal to compound more efficiently over time.

This guide serves as a comprehensive hub to help you navigate the nuances of annuity taxation. Because the rules change based on whether your funds are qualified or non-qualified, though it may seem complicated, it’s important to understand the specific mechanics of your contract.

In this guide, we will cover:

• Qualified vs. Non-Qualified Rules: How the source of your funds dictates your tax bill.
• 1035 Exchanges: How to swap contracts without triggering a tax event.
• Inherited Annuities: What beneficiaries need to know about tax liabilities.
• RMDs and Early Withdrawals: Navigating age-related IRS requirements and penalties.
• Special Circumstances: How state taxes and divorce settlements impact your bottom line.

We’ve broken these complex rules down into clear, manageable sections, each of which links to a more detailed exploration of the topic so that you have all the information you need to move forward with confidence.

Are Annuities Tax-Free? (Tax Deferral Explained)

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 earn and which tax bracket you fall into in 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.

Qualified vs. Non-Qualified Annuities and How They're Taxed

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).

How Non-Qualified Annuities Are Taxed + Exclusion Ratio

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.

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 Payout Type

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 your 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.

What Is a 1035 Exchange?

A 1035 exchange is a provision in the IRS tax code that allows you to transfer funds from an existing annuity to a new one without paying taxes on the investment gains at the time of the transfer. Named after Section 1035 of the Internal Revenue Code, this rule classifies the move as a "like-kind" exchange. This means the IRS views the transaction as a continuation of your original investment rather than a withdrawal, allowing your money to keep growing tax-deferred in a contract that might offer better rates or features. 

To qualify for a 1035 exchange, the transaction must meet specific IRS requirements:

• Direct Transfer: The funds must move directly from one insurance company to another. If you receive a check and deposit it yourself, the IRS may view it as a taxable distribution.
• Same Ownership: The owner and the annuitant must be the same on both the old and new contracts.
• Like-Kind Products: You can exchange one non-qualified annuity for another, or even exchange a life insurance policy for an annuity.

However, certain actions can disqualify an exchange. For example, you cannot exchange an annuity for a life insurance policy, and you can’t change the primary owner of the contract during the transfer. While a 1035 exchange avoids immediate taxes, it is important to check for any surrender charges from your current provider before making the switch.

Early Withdrawals, Penalties & Surrender Charges

When you take money out of an annuity before the agreed-upon time, you may encounter two entirely different types of costs. It is a common misconception that these are the same thing, but they are actually charged by two different parties for different reasons.

1. The IRS Early Withdrawal Penalty

The federal government provides tax deferral on annuities to encourage long-term retirement saving. Because of this, the IRS generally imposes a 10% early withdrawal penalty if you take money out of your annuity before you reach age 59½. This penalty applies only to the earnings portion of your withdrawal (the interest you’ve gained) and is paid directly to the IRS when you file your taxes.

There are a few specific exceptions where the IRS may waive this 10% penalty, such as:

• Total, permanent disability
• The withdrawal is made by a beneficiary after the owner's death
• The payments are taken as a series of substantially equal periodic payments

2. Insurance Company Surrender Charges

Separate from the IRS, the insurance company that issued your annuity may apply a surrender charge if you withdraw more than a certain amount during the first few years of your contract. These charges are designed to help the insurer recoup the costs of setting up the contract and are defined by a "surrender schedule" in your policy—typically starting higher (e.g., 7–9%) and decreasing to 0% over several years.

It’s good to look for an annuity that has liquidity options. Some do not offer any penalty free withdrawals, some allow for penalty free withdrawals of RMDs on qualified contracts, and some have a percentage that they allow starting in year one or two of the contract.

Inherited Annuity Taxation

Inherited annuities are generally taxable, but the timeline for paying those taxes depends on your relationship to the deceased and whether the annuity was qualified or non-qualified. When you inherit an annuity, the IRS does not allow the tax-deferral to continue indefinitely. As a beneficiary, you must eventually distribute the funds and report the taxable portion as ordinary income.

Spousal Continuation

If you are the surviving spouse and the sole beneficiary, you typically have the option to continue the contract as your own. This is often the most tax-advantageous path, as it allows the money to remain tax-deferred until you choose to take withdrawals later in life.

Non-Spouse Beneficiaries: The 5 and 10-Year Rules

For non-spouse beneficiaries—such as adult children—the IRS mandates a specific window for emptying the account:

• The 10-Year Rule (Qualified Annuities): Under the SECURE Act, if you inherit a qualified annuity (one held within an IRA or 401(k)), you must generally withdraw all funds by December 31 of the 10th year following the owner’s death.
• The 5-Year Rule (Non-Qualified Annuities): If the annuity is non-qualified (funded with after-tax dollars) and held outside of a retirement account, the default requirement is often the "5-Year Rule." This requires the entire balance to be distributed within five years of the owner’s death.

The "Stretch" and Other Exceptions

While the SECURE Act eliminated the "stretch" option for most, certain Eligible Designated Beneficiaries (such as those who are disabled, chronically ill, or minor children) may still be able to take distributions over their own life expectancy. Additionally, some annuities purchased before 2019 may be grandfathered under older, more flexible rules.

Because the penalties for missing a required distribution can be steep, we always recommend consulting a tax advisor to review your specific contract.

Additional Annuity Tax Rules

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

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, you can 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 of 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 it will shift 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 significant IRS penalties.

• Learn more: A Guide to Annuity RMD Rules

Annuity Taxation in Divorce

Annuities are subject to specific tax rules during a divorce, primarily governed by a Qualified Domestic Relations Order (QDRO) for qualified contracts. If an annuity is split or transferred as part of a divorce settlement using the proper legal channels, it is typically treated as a non-taxable event. This allows the funds to maintain their tax-deferred status. However, if the transfer is not executed correctly—such as one spouse withdrawing the cash first to pay the other—it can trigger immediate income taxes and early withdrawal penalties.

State Taxes on Annuities

State taxes on annuities vary significantly depending on where you live, as some states follow federal guidelines while others offer unique exemptions. While the federal government taxes the earnings portion of annuity distributions as ordinary income, state laws are a patchwork. Some states do not tax retirement income at all, while others may tax a portion of your annuity or apply a premium tax on the initial investment. It is important to check the specific tax laws in your state to understand how they will impact your net retirement income.

• Further Reading: How to Choose Between Annuities, 401(k)s, and IRAs

Frequently Asked Questions About Annuity Taxation

Are annuities taxable?

Yes, annuities are taxable, but the portion of the payout that is taxed depends on how the annuity was funded. For qualified annuities (like those in an IRA), the entire distribution is generally taxed as ordinary income because the money was never taxed before. For non-qualified annuities, you only pay taxes on the interest earnings, while your original principal is returned to you tax-free.

What tax rate applies to annuity income?

Annuity earnings are taxed at your ordinary income tax rate for the year in which you receive the distribution. Unlike some investments that qualify for lower long-term capital gains rates, annuity growth is treated the same as a standard paycheck or interest from a bank account. Depending on your primary residence, state income taxes may also apply to these payouts.

Are Roth annuity payouts taxed?

Qualified Roth annuity distributions are generally federal income tax-free, provided you meet specific IRS requirements. To avoid taxes on the earnings, you must typically have held the account for at least five years and be at least 59½ years old. Because Roth rules are strict, it is always best to confirm your eligibility for tax-free withdrawals with a tax professional.

How is a tax-deferred annuity different from a tax-free annuity?

A tax-deferred annuity postpones your tax bill until a later date, whereas a tax-free account (like a Roth IRA) may eliminate taxes on earnings entirely. With a deferred annuity, you aren’t avoiding the IRS; you are simply waiting to pay them so your money can grow more efficiently in the meantime. Most annuities are tax-deferred, meaning you will eventually owe ordinary income tax on any interest earned.

Can I move my annuity to a new contract without paying taxes?

Yes, you can move your funds to a new contract without triggering a tax event by using a 1035 exchange. This IRS-approved process allows for a direct transfer between insurance companies, ensuring the government views the move as a continuation of your investment rather than a taxable withdrawal. To learn more about the rules for these transfers, see our comprehensive guide to 1035 exchanges.

Do annuities have required minimum distributions (RMDs)?

Qualified annuities held within an IRA or 401(k) are subject to RMDs, while non-qualified annuities held outside of retirement accounts are not. Under SECURE 2.0, you must generally begin taking these distributions at age 73 (increasing to 75 in 2033). If you fail to take your RMD from a qualified annuity, you could face significant IRS penalties. For more details, read our full guide on annuity RMD rules.

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