Are Annuities Taxable? How Annuity Taxes Work (2026)

How annuity taxation works at a high level

Money inside an annuity grows without a current tax bill. The IRS only gets involved once you touch the money, whether that is a withdrawal, an income payment, or cashing out the whole contract, and whatever counts as a gain is always ordinary income, regardless of how many years you held the contract. How much of that withdrawal is taxable comes down to how the annuity was originally funded:

Do you owe tax when you take a withdrawal

Usually, at least partly, and it depends on the contract type and whether you have already annuitized, meaning converted the balance into a stream of payments.

For a non-qualified annuity that has not been annuitized, the IRS applies a last-in-first-out rule: your earnings come out before your basis does, and every dollar of those earnings is ordinary income. Say you deposited $100,000 into a non-qualified contract that has since grown to $130,000. Pull out $20,000, and the entire $20,000 is taxable, because it is drawn from the $30,000 of gains sitting on top of your original deposit. A qualified annuity works differently, since none of the money going in was ever taxed, so withdrawals are generally taxable in full.

Once a non-qualified contract is annuitized, the exclusion ratio takes over and splits each check between principal and gain. Picture a $160,000 contract funded with $120,000 of after-tax money: dividing $120,000 by $160,000 gives a ratio of 75 percent, so 75 cents of each payment comes back untaxed and the other 25 cents is treated as income, continuing that way until you have recovered the full $120,000. From then on, every remaining check is taxable in full.

Taking a taxable withdrawal before age 59 and a half typically triggers an extra 10 percent IRS penalty on top of ordinary income tax. Disability, a death benefit paid to a beneficiary, and a properly structured 72(t) series of substantially equal payments are among the recognized exceptions.

What beneficiaries owe on a death benefit

When the original owner dies, the person who inherits the contract owes ordinary income tax on the portion of the death benefit that represents earnings. Unlike stocks or mutual funds, an annuity's cost basis does not reset, or step up, at death, so the original basis carries forward to the beneficiary. Most contracts give a beneficiary a few ways to take the money, and the choice affects the timing of the tax bill:

• Lump sum. All the taxable gain lands in one tax year, which risks bumping the beneficiary up into a steeper bracket.
• Five-year rule. The distribution can be spread across five years to soften the tax hit.
• Lifetime payout. Some contracts let the beneficiary stretch payments over their own life expectancy.
• Spousal continuation. A surviving spouse can often step into the owner role on the existing policy and go on deferring tax the same way the original owner did.

Are inherited annuities taxed

Yes, but only on the gain, never on the money that was already taxed going in. A non-qualified inherited annuity gets taxed on its earnings as each payout happens. A qualified inherited annuity, one sitting inside an IRA or 403(b), instead follows the rules for inherited retirement accounts: the SECURE Act generally gives a non-spouse heir a 10-year window to drain the account, with ordinary income tax due on essentially everything that comes out. Whichever path applies, the gain itself is always ordinary income and never gets the lower capital gains treatment.

The tax rules for non-qualified annuities

A non-qualified annuity is purchased with money you already paid tax on, outside of any retirement account, so only the growth above your basis is ever taxable. That growth compounds tax-deferred, pre-annuitization withdrawals follow the LIFO rule described above, annuitized payments split by the exclusion ratio, and the 10 percent early withdrawal penalty applies to any taxable amount pulled out before age 59 and a half unless an exception fits.

The tax rules for qualified annuities

A qualified annuity lives inside a tax-advantaged account and was funded with pre-tax or deductible dollars, which is why distributions are generally fully taxable as ordinary income. A few specifics worth knowing:

• Required minimum distributions. Current law requires you to begin taking money out at age 73 from most qualified accounts, and skipping that draws a penalty tied to the shortfall.
• Roth annuities. Held inside a Roth IRA, qualified withdrawals can come out completely tax-free once you satisfy the five-year holding period and age requirement.
• Reporting. The insurance company reports your taxable amount each year on IRS Form 1099-R.

Ways to manage the tax bill

• Choose your years carefully. Time non-qualified withdrawals for years when your other income is already low, so the extra taxable amount lands in a cheaper bracket.
• Annuitize for steady income. Letting the exclusion ratio do its job spreads the taxable portion thin over many years rather than in one lump.
• Use a 1035 exchange. IRS Section 1035 allows a tax-free trade of one non-qualified contract for a new one, carrying your basis over and pushing the bill down the road rather than making it disappear. See our 1035 exchange guide.
• Let a spouse continue the contract. A surviving spouse who takes over the annuity can keep deferring taxes indefinitely.
• Watch your state's rules too. Some states also tax annuity income, so check your state's treatment, especially if you have relocated.