The Tax Journey of an Annuity
Every annuity moves through the same three stages. Taxes generally show up at the third stage — but the treatment at that point traces back to the money you started with.
- Stage 01
Money Goes In
The contract is funded — either with money already held inside a tax-qualified retirement arrangement, or with after-tax dollars held outside one.
- Stage 02
Money Grows
Earnings inside a deferred annuity generally are not taxed annually as they accumulate. This is what people mean by tax deferral.
- Stage 03
Money Comes Out
Withdrawals, income payments and death benefits are where federal income tax generally becomes relevant — and where the two starting points diverge.
Where the money came from decides what happens next
Qualified Annuity
Typically an annuity held within a tax-qualified retirement arrangement, such as a traditional IRA or another qualifying retirement plan.
- Traditional qualified retirement money generally has not yet been subject to income tax.
- Distributions are therefore generally taxable as ordinary income, subject to applicable rules.
- Applicable required minimum distribution rules may apply to the underlying account.
Non-Qualified Annuity
Generally purchased with money that has already been subject to income tax, held outside a qualified retirement account.
- Your investment in the contract and the contract’s earnings are treated differently for federal income-tax purposes.
- Withdrawals before annuitization are generally treated as coming from earnings first, subject to applicable rules.
- Not automatically subject to the same required minimum distribution rules as qualified accounts.
General federal income-tax concepts shown for education. State tax treatment, contract terms, plan rules and individual circumstances can change the outcome.
Tax-Deferred Doesn’t Mean Tax-Free
Inside a deferred annuity, interest or other earnings generally are not taxed each year as they accumulate. There is generally no annual tax bill on those earnings simply because the contract value went up.
In practical terms, money that might otherwise have gone to pay current taxes on earnings can remain inside the contract. That’s the mechanic behind the phrase “tax-deferred growth.”
Qualified vs. Non-Qualified Annuities: Why It Matters
This distinction is not a technicality. It generally determines how much of a distribution is taxable when money comes out.
Qualified Annuity
Typically held inside a traditional IRA or another qualifying retirement arrangement.
Non-Qualified Annuity
Held outside a qualified retirement account.
Qualified Annuity
Funded with money that generally has not yet been subject to income tax.
Non-Qualified Annuity
Generally funded with money that has already been subject to income tax.
Qualified Annuity
Distributions are generally taxable as ordinary income, subject to applicable rules.
Non-Qualified Annuity
Earnings are generally taxable; your investment in the contract generally is not taxed again.
Qualified Annuity
The underlying account may be subject to applicable required minimum distribution rules.
Non-Qualified Annuity
Not automatically subject to the same required minimum distribution rules.
Qualified Annuity
Non-Qualified Annuity
Typically held inside a traditional IRA or another qualifying retirement arrangement.
Held outside a qualified retirement account.
Funded with money that generally has not yet been subject to income tax.
Generally funded with money that has already been subject to income tax.
Distributions are generally taxable as ordinary income, subject to applicable rules.
Earnings are generally taxable; your investment in the contract generally is not taxed again.
The underlying account may be subject to applicable required minimum distribution rules.
Not automatically subject to the same required minimum distribution rules.
Educational comparison of general federal income-tax concepts. Plan rules, contract terms and individual circumstances vary.
That doesn’t mean an annuity inside an IRA is inappropriate. It means the evaluation should focus on what the contract actually adds — insurance features, guarantees, income benefits, principal protection or other contract characteristics — rather than on tax deferral the retirement account already provides.
What Happens When You Withdraw Money?
For a non-qualified deferred annuity, the general federal rule for certain withdrawals taken before annuitization is that earnings are treated as coming out before your investment in the contract.
In other words, the taxable portion generally comes out first, subject to applicable tax rules.
Hypothetical Example — for educational purposes only
How a Withdrawal May Be Viewed
Susan purchases a non-qualified annuity with $100,000 of after-tax money. Years later, the contract is worth $130,000.
- Contract Value
- $130,000
- Investment in Contract
- $100,000
- Earnings
- $30,000
Hypothetical value at the time of the withdrawal.
After-tax money Susan originally paid in.
The portion generally treated as taxable when distributed.
Conceptually, if Susan takes a withdrawal before annuitizing, the general federal rule treats the distribution as coming from the $30,000 of earnings first. Amounts treated as earnings generally are includible in income; amounts treated as a return of her investment in the contract generally are not taxed again.
Additional taxes, contract charges, surrender charges, rider terms and age-based rules may also apply — and the analysis can differ for annuities held inside qualified retirement accounts.
Hypothetical example for educational purposes only. It does not reflect a specific product, rate of return or individual tax situation, and it does not attempt to address every distribution scenario. Consider consulting a qualified tax professional about your circumstances.
What If You Turn the Annuity Into Income?
Taxation can work differently once a non-qualified annuity is annuitized — that is, converted into a stream of payments rather than accessed through withdrawals.
The Exclusion Ratio, in Plain English
When a non-qualified annuity is annuitized, each qualifying payment may be viewed as having two components rather than being fully taxable.
One Annuity Payment
Non-qualified annuity that has been annuitized.
Return of Investment in the Contract
A portion of a qualifying payment may represent the after-tax money you originally paid in, which generally is not taxed again.
Taxable Portion
The remaining portion of the payment generally represents earnings and generally is includible in income.
How much of each payment is excluded from income depends on the contract, the payout selected and applicable federal tax rules — and the treatment can change once amounts equal to your investment in the contract have been recovered. This is a conceptual illustration, not a tax calculation.
What About Withdrawals Before Age 59½?
Taxable amounts distributed from an annuity before age 59½ may be subject to an additional 10% federal tax on top of ordinary income tax, unless an exception applies.
What About Required Minimum Distributions?
This is one of the most common points of confusion, and the distinction is fairly simple.
In short: RMD exposure generally follows the type of account, not the fact that you own an annuity. Applicable rules and exceptions can vary, so confirm how they apply to your specific accounts.
What Happens to an Annuity at Death?
Inherited annuity taxation is its own subject, and the outcome can depend on several factors:
- Whether the annuity is qualified or non-qualified
- The relationship of the beneficiary to the owner
- The terms of the contract
- The payout method the beneficiary selects
- Applicable tax law at the time
7 Tax Questions to Ask Before Buying an Annuity
- Will this annuity be qualified or non-qualified?
- Has the money I’m using already been taxed?
- How will withdrawals generally be taxed?
- What happens if I need money before age 59½?
- How would income payments be taxed?
- What happens tax-wise when I die?
- Should I review this strategy with my tax professional?
The Bottom Line: Understanding the Tax Rules Is Part of Understanding the Annuity
Annuities can provide tax-deferred growth, but tax-deferred doesn’t mean tax-free. The tax treatment can vary significantly depending on whether the annuity is qualified or non-qualified, how distributions are taken and the owner’s individual circumstances.
That’s why taxes shouldn’t be evaluated in isolation.
Sources
- 1.Publication 575 — Pension and Annuity Income — Internal Revenue Service
- 2.Publication 590-B — Distributions from Individual Retirement Arrangements (IRAs) — Internal Revenue Service
- 3.Retirement Topics — Exceptions to Tax on Early Distributions — Internal Revenue Service
- 4.Retirement Topics — Required Minimum Distributions (RMDs) — Internal Revenue Service
- 5.Annuities — Investor Publications — U.S. Securities and Exchange Commission (Investor.gov)
Go deeper in the Knowledge Hub
Educational guides that expand on the topics covered in this article.
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