How Fixed Index Annuity Taxes Work

Tax-deferred growth: the core benefit of an FIA

Money inside a fixed index annuity grows without an annual tax bill. Interest your contract credits each year stays inside the policy and keeps compounding untaxed until you actually take it out. That feature is called tax deferral, and it is the main reason retirement savers pick an annuity over a taxable account for money they will not touch for years.

Compare that to a bank CD. A CD sends you a 1099-INT every January, and you owe income tax on that interest even if you never touch the account. An FIA generates no 1099 for interest it credits along the way. The IRS only gets involved once money actually leaves the contract.

Here is what that looks like in practice. Picture someone age 58 who puts $200,000 into a 10-year FIA that averages a 6% index credit a year. By the time it matures, that account has grown to roughly $358,000, and not one dollar of that growth has been reported to the IRS yet. Withdrawals starting at age 68 then owe ordinary income tax on the $158,000 gain, and that bill can be spread across several retirement years rather than landing in one lump sum.

The LIFO rule on non-qualified withdrawals

A contract you funded with money the IRS had already taxed is called non-qualified, and its withdrawals follow an ordering rule the IRS calls LIFO, short for Last In, First Out. Any interest the policy has earned is pulled out ahead of your original premium, not after it. That means every withdrawal is taxable income right up until the accumulated gain is gone; from that point on, what comes out is simply your cost basis returning to you, untaxed.

Picture a $150,000 premium that has grown into a $210,000 contract, a $60,000 gain. Pull $30,000 out of that policy and the whole amount is taxable, because the gain sitting in the contract is twice as large as the withdrawal itself.

This is one reason many FIA owners wait until retirement to start withdrawals: their ordinary income bracket is usually lower once regular paychecks stop.

The 10% early withdrawal penalty

Take a taxable withdrawal before age 59 and a half, and the IRS adds a 10% penalty on top of whatever income tax you already owe. It does not replace that tax bill, it stacks on it.

Example: a 55-year-old pulls $25,000 from a non-qualified FIA that has more than enough gain to make the entire withdrawal taxable under LIFO. In the 22% federal bracket, that means $5,500 in income tax plus a $2,500 penalty, for $8,000 in combined cost. The $25,000 withdrawal nets out to $17,000.

A handful of exceptions waive the 10% penalty:

• Death of the contract owner. A beneficiary never owes the 10% penalty on money they inherit.
• Total and permanent disability, using the IRS definition.
• A fixed schedule of substantially equal periodic payments under IRS Section 72(t). Once you begin this schedule, the payments generally must run for a minimum of five years, and you have to keep taking them until you turn 59 and a half if that milestone lands later.

Keep the two charges separate in your head. Your carrier's surrender charge and the IRS's 10% penalty come from different places, and withdrawing early enough during the surrender period can trigger both at once.

Qualified vs. non-qualified FIAs

Whether your contract is qualified or non-qualified decides how every withdrawal gets taxed.

Non-qualified FIAs

This contract holds money you already paid tax on before you deposited it. Only the growth gets taxed when you take it out, following the LIFO order described above, and your original deposit eventually comes back to you free of tax.

• No limit on how much you can deposit
• No required minimum distributions, ever
• Only the earnings portion of a withdrawal is taxed
• The 10% penalty still applies before age 59 and a half

Qualified FIAs, funded from an IRA or 401(k)

This contract holds pretax money rolled over from a retirement account. Because none of it was ever taxed, there is no cost basis to protect. Every dollar you withdraw, whether you think of it as principal or gain, counts as ordinary income.

• Required minimum distributions begin at age 73 under SECURE 2.0
• The 10% early withdrawal penalty still applies before age 59 and a half
• There is no LIFO split; the entire withdrawal is taxable
• Your required distribution is calculated on the full contract value, not just the gain

An IRA rollover funds most FIA contracts sold today, which means most FIA owners should plan on ordinary income tax hitting every single dollar they eventually withdraw.

Two setups break that pattern. Money inside a Roth IRA was already taxed going in, so a Roth-funded FIA pays out with no further tax once you clear age 59 and a half and the account has existed for five years. Separately, turning a non-qualified FIA into a series of income payments, rather than taking occasional withdrawals, lets an exclusion ratio split each check between taxable interest and an untaxed slice of your own principal, which softens the tax hit on steady lifetime income.

Required minimum distributions on qualified FIAs

If your FIA holds IRA or 401(k) money, required minimum distributions start at age 73 under SECURE 2.0. Your carrier arrives at the amount by dividing what the contract was worth on the last day of the prior calendar year by an IRS life expectancy factor tied to your age. Set up an annual RMD election and most carriers will run that math and send the payment without you having to ask each year.

Skipping a required distribution is expensive. The IRS charges a 25% excise tax on the amount you should have withdrawn but did not, cut to 10% if you correct the mistake quickly.

Most FIA contracts let you withdraw at least 10% of the contract value each year without a surrender charge, which usually covers a typical RMD. If your contract is large, or other IRA balances push your total required distribution higher, confirm the free withdrawal allowance actually covers what you owe before the deadline. Our RMD calculator can help you check the number.

The 1035 exchange: moving money without triggering tax

A 1035 exchange lets you move the cash value of one annuity directly into another without the IRS treating the move as a taxable event. Your cost basis carries over to the new contract. You are deferring the tax, not erasing it.

This tool matters most when you want out of an older annuity with weak terms and into a newer FIA with better caps, lower fees, or a stronger income rider. Surrender the old contract yourself and take a check, and you owe tax on the gain that year. Route the same money through a 1035 exchange instead, and nothing is due until you eventually withdraw from the new contract.

A valid exchange has to follow a few rules:

• The insurers handle the transfer between themselves; if you take a check personally and redeposit it later, the exchange does not qualify.
• Only another annuity can receive the money. A mutual fund or a bank account will not work as the destination.
• You are allowed to move just part of an existing contract rather than the whole thing.
• A surrender charge from your original carrier can still apply, tax-free status or not.
• Whatever gain had built up follows the money into the new contract and gets taxed the day you finally withdraw it.

What happens to an inherited FIA

How an inherited contract gets taxed depends on who inherits it and how it was funded. Our guide to annuity beneficiary options covers the mechanics of naming and changing who receives the money.

When a spouse inherits

A surviving spouse has the most flexibility of any beneficiary. Through spousal continuation, they can take over the contract as their own, keep its tax-deferred status, and are not required to take any immediate distribution. Nothing is taxed at the moment of inheritance.

When a non-spouse inherits a non-qualified FIA

A non-spouse beneficiary generally has to distribute the entire contract within 5 years of the owner's death. Whatever comes out above the original cost basis counts as ordinary income. The 10% early withdrawal penalty never applies to an inherited annuity, regardless of the beneficiary's age.

When a non-spouse inherits a qualified FIA

For an IRA-funded contract, the SECURE Act of 2019 and its 2022 follow-up, SECURE 2.0, force most non-spouse beneficiaries to drain the account within a decade. A smaller carve-out group, the eligible designated beneficiaries, keeps the older stretch option based on their own life expectancy: this covers a chronically ill or disabled beneficiary, a minor child of the account owner, a beneficiary close in age to the owner (within about 10 years), and a surviving spouse. Whatever comes out of an inherited qualified FIA counts as ordinary income, and here too, the 10% penalty never applies.

Death benefit riders

An enhanced death benefit rider can pay a beneficiary more than the contract's account value, but the tax treatment does not change. Anything above the original cost basis, including the enhanced portion, is taxed to the beneficiary as ordinary income.

Common tax mistakes FIA owners make

• Missing a required minimum distribution. The IRS penalty runs 25% of the amount you should have withdrawn. Set up automatic RMD processing with your carrier well before you turn 73.
• Mixing up a carrier's surrender charge with the IRS's early withdrawal penalty. They come from different places, and you can owe both on the same withdrawal.
• Taking a large withdrawal in a high-income year. If you have flexibility, take distributions in years when your other income is lower, since ordinary income rates apply to every dollar.
• Surrendering an old annuity for cash instead of using a 1035 exchange. Cashing out is a taxable event the year you do it; an exchange is not.
• Assuming a beneficiary can stretch payments over decades. The SECURE Act ended most stretch strategies for non-spouse beneficiaries, so plan for a 5 or 10 year payout instead.
• Wrapping a standard FIA inside an account that is already tax-free, like a Roth IRA. The Roth wrapper already shelters the money from tax, so the annuity's deferral feature does nothing extra, and you still absorb the annuity's built-in insurance costs for no offsetting benefit.

Tax rules around annuities change, and your own situation may not match the examples above exactly. Talk to a tax professional before making withdrawal or beneficiary decisions, especially near a large distribution or an inherited contract.