How Are Annuities Taxed?

It depends on your contributions

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Annuities are insurance contracts that offer unique guarantees and tax deferral, and they are commonly used to save for retirement. But when you begin to draw money from an annuity, those funds may be taxed, reducing how much you have to spend. The extent to which your annuity is taxed depends on the type of money in it (that is, whether it’s from pre-tax or after-tax sources) as well as how you receive distributions. In some cases, you might not have to pay income tax at all.

To estimate how much you can actually spend from an annuity, it’s critical to understand the tax rules. We’ll outline some of the most important features to consider as you plan for the future.

Key Takeaways

  • Annuities can provide tax-deferred growth while funds are inside of the contract, but you may eventually pay taxes on withdrawals.
  • When using qualified annuities with pre-tax money, plan for the eventual tax bill so that you know how much you can spend after taxes. 
  • With non-qualified contracts, tax payments might be front-loaded as you spend down the earnings—unless you annuitize the contract and use the exclusion ratio.
  • If contributing to an annuity in a designated Roth account, you could pay no taxes on qualified distributions.

What Is an Annuity?

An annuity is an insurance contract designed to help investors with long-term goals. These insurance products offer a variety of guarantees, such as lifetime income, and any earnings inside of an annuity contract are tax-deferred.

In its most basic form, an annuity pays out income that lasts for a specified length of time—whether that’s 20 years or the rest of your life. That income stream can be helpful when you want to replace a regular paycheck after you retire.

You can choose to save money in a “deferred annuity” years in advance of receiving income, or you can purchase an “immediate annuity” with a lump sum in exchange for a guaranteed stream of payments.

That said, you don’t necessarily need to take income from an annuity. For example, deferred annuities allow you to deposit money into an annuity contract and decide when (if ever) to begin income payments. Immediate annuities, on the other hand, typically begin paying out income within 12 months of the purchase date.


The IRS assesses a 10% early withdrawal penalty, in most cases, if you withdraw funds before you turn 59 ½. Insurance companies frequently assess surrender charges if you withdraw money during the surrender period—which can last well over a decade, depending on the company. For these reasons, annuities are for long-term savings only and it's essential to compare different annuities before buying.

Are Annuities Taxable?

The tax treatment of contributions, withdrawals, and income depends on several factors. We’ll dig into the details below, but first, it’s important to distinguish between qualified annuities, non-qualified annuities, and Roth accounts.

  • Qualified annuities: An annuity funded with pre-tax dollars is often a qualified annuity. For example, if your annuity is part of an employer-sponsored retirement plan like a 401(k) or a SIMPLE IRA, you may be able to make pre-tax contributions.
  • Non-qualified annuities: Non-qualified annuities are generally funded with after-tax contributions. For example, if you write a check from your bank account to pay into an annuity (and it’s not an IRA), it is likely a non-qualified contract.
  • Roth accounts: Depending on the type, these can be either qualified or non-qualified plans. Designated Roth accounts, such as a Roth 403(b) or Roth 401(k), may be available through your employer, or you can invest in a Roth IRA on your own. Either way, contributions are after-tax.

How Annuities Are Taxed

Any growth or earnings inside of an annuity are tax-deferred until you start receiving income from the annuity. But taxation on contributions and withdrawals depends, in part, on whether or not the contract is a qualified or non-qualified annuity.

Qualified Annuity Taxes

When using a qualified annuity (such as one in an employer’s retirement plan) or a traditional IRA, the contributions you make typically reduce your taxable income for the year in which you contribute. For example, pre-tax contributions to a 401(k) annuity can lower your taxable income. However, you must eventually pay taxes when you take distributions from pre-tax accounts. That money has never been taxed, and the IRS treats the entirety of those distributions as ordinary taxable income.


If you annuitize an annuity (that is, convert it into a stream of guaranteed payments) in which you deposited pre-tax contributions, you still pay taxes on the entire amount you receive.

Non-Qualified Annuity Taxes

Contributions to a non-qualified annuity—essentially, one that is not in a retirement plan—are generally not tax-deductible. (If you're contributing to a traditional IRA, see the prior section). Because the money you use to fund the annuity has already been taxed, you can withdraw your principal tax-free (early withdrawals may be subject to the IRS penalty tax and/or surrender charges). However, any earnings inside of the annuity contract will be taxed when they're withdrawn.

When taking a lump-sum distribution from a non-qualified annuity, the IRS treats the withdrawal as last-in-first-out (LIFO). Your contribution went in first, and the earnings were added later (or “last”), so the earnings are withdrawn first. As a result, distributions are fully taxable until you take out all of the earnings. After that, withdrawals of your “basis,” or your original contributions, come out tax-free.

If you annuitize an annuity outside of a retirement plan (as opposed to making one or more self-directed withdrawals), your payments may be partially taxable. The IRS allows you to use an “exclusion ratio” to treat a portion of each payment as a tax-free return of your basis. The remainder of the payment is treated as earnings, which will be taxed as ordinary income. If payments continue long enough to use all of the principal, payments you receive thereafter become fully taxable.

Taxes on Annuities in Roth Accounts

If the annuity is in a Roth account, such as a Roth 401(k) or a Roth IRA, your contributions are included in your taxable income the year you make them. Because you’ve already paid taxes on those contributions, you’re not taxed on qualified distributions taken from the annuity—whether those are withdrawals or annuity payments. Qualified distributions are, generally, those made after you turn 59 ½ and the account has been open for five years.

Since qualified distributions from Roth accounts are designed to be tax-free and annuities can deliver lifelong payments, an annuity in such an account can potentially deliver tax-free income for life.

Qualified Annuity Non-Qualified Annuity Roth Account
Contributions Pre-tax Generally after-tax After-tax
Withdrawals Fully taxable LIFO on earnings with tax-free return of basis Qualified distributions are tax-free
Annuitization Fully taxable May be partially taxable Qualified distributions are tax-free

Tax Rules for Inherited Annuities

When you inherit an annuity, the tax rules are similar to everything described above: 

  • Qualified annuity distributions are fully taxable.
  • Lump-sum distributions (withdrawals) from non-qualified annuities are broken down into basis and earnings. The earnings come out (and are taxed) first, and the basis comes out after the earnings are exhausted.
  • Annuitized contracts often stop making payments after the death of the annuitant (the person entitled to receive the annuity’s benefits). However, if a contract continues to pay income, the exclusion ratio rules remain the same.

Additional rules and opportunities may apply when you inherit an annuity. For example, you may be able to roll qualified assets over to an IRA, or you might be required to distribute the funds within a specific timeframe. Check with a CPA to learn about the requirements and avoid tax penalties.

Frequently Asked Questions (FAQs)

How do I avoid paying taxes on an inherited annuity?

The death of a contract owner does not eliminate taxation on an annuity. However, you may be able to avoid early withdrawal penalties if you take distributions from an inherited annuity before age 59 ½.

How do I use the General Rule to determine an annuity’s taxation?

If you’re eligible to use the General Rule, you can exclude a portion of an annuity payment or distribution from your income. To figure out the appropriate amount, use the IRS-provided worksheets from Publication 939. A professional tax preparer or CPA can verify that you claim the correct amount.

What type of annuity will cause immediate taxation of interest earned?

Interest you earn within an annuity will only be taxed once it comes out of the annuity. If you take a one-time distribution from an annuity that's not in a retirement account, interest earnings are treated as last-in-first-out (LIFO). Any money you receive (self-directed withdrawals or annuity payments) from an annuity in a non-Roth retirement account will be taxed as income in the year you receive it.

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  1. "Publication 575 (2020), Pension and Annuity Income."

  2. "Publication 590-B (2020), Distributions from Individual Retirement Arrangements (IRAs)."

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