How Annuity Withdrawals Are Taxed (How We Reduced Taxable Income by $35K)

How annuity withdrawals are taxed: gain comes out first

Withdrawals from a non-qualified deferred annuity are taxed last-in, first-out (LIFO). The IRS treats every dollar you take out as interest until all the gain is gone. Only then do you reach your original premium, which comes back tax-free.

That is the opposite of what most people expect. If your annuity has grown by $80,000 and you take out $40,000, the full $40,000 is ordinary income, even though most of the contract is your own money. For the basics on how annuities are taxed, see Are Annuities Taxable?

The one way to get to principal is to use up the gain in that contract. With one big contract, that takes a long time. With several small ones, you can empty one completely.

Our client’s setup: $250,000 split into ten $25,000 MYGAs

The client had $250,000 to put into fixed annuities. Instead of one contract, he bought ten separate $25,000 MYGAs with staggered terms.

His reason was interest rate risk. With one big contract, his whole balance renews at whatever rates happen to be available on a single date.

With an annuity ladder, a rung comes due every year or so, and each one renews into the market of its own moment. Shopping each term separately also let him take the best-paying carrier at each length, which usually means several different insurers. You can compare today’s MYGA rates by term the same way.

That last detail turns out to matter a lot for taxes.

The real example: $40,000 in year five

In year five, the client needed $40,000. The ladder cut his taxable income on that withdrawal from $40,000 to about $15,000.

His 5-year MYGA had just matured. The $25,000 he put in had grown to $33,721.25, about 6.17% a year.

He cashed it out in full, which meant $8,721.25 of gain and $25,000 of tax-free principal. He took the remaining $6,278.75 from another rung, all of it gain.

Same money, same growth, same withdrawal. The only difference was how many contracts held it. In the 22% bracket, that gap is roughly $5,500 in federal tax.

The trap: the IRS aggregation rule

This strategy only works if the contracts count as separate annuities, and the IRS has a rule built to stop people from faking that. Under the aggregation rule, all deferred annuities issued by the same insurance company to the same owner in the same calendar year are treated as one contract when figuring the taxable part of a withdrawal (IRC §72(e)(12)^[1]). Congress applied it to affiliated insurers too.

Buy ten $25,000 MYGAs from one carrier on the same day, and the IRS sees one $250,000 annuity. The $40,000 withdrawal would be fully taxable, exactly as if you had never split it.

To keep the rungs separate for tax purposes, use either:

• Different, unaffiliated carriers, which a rate-shopped ladder usually does anyway, or
• Different calendar years for contracts from the same carrier.

Ask which carriers share a parent company before you assume two rungs are separate. Brand names can hide a common owner.

The fine print before you copy this

The tax math is the easy part. Three other rules decide whether the withdrawal actually works.

• Surrender charges. The 5-year rung was free to cash out because it had matured. The other $6,278.75 came from a rung still in its surrender period. Most MYGAs allow about 10% of the balance penalty-free each year, roughly $3,370 on a $33,700 rung. Taking $6,278.75 from one rung would likely trigger a charge; splitting it between two rungs keeps each draw inside its free amount.
• The 10% IRS penalty. Gain withdrawn before age 59½ generally carries a 10% federal penalty on top of income tax. The ladder shrinks the taxable amount, but it does not waive the penalty on what remains.
• Matured rungs in earlier years. In a ladder with 1- to 4-year rungs, those contracts matured before year five. Whatever you did with them then, renew, move, or spend, changes what is available later.

Run the specific withdrawal past your tax preparer before you take it. The order you pull from matters.

Build a ladder that does both jobs

A well-built MYGA ladder manages rate risk and gives you control over when you pay tax. Getting both depends on the details: which carriers, which terms, which years, and which rung you draw from first.

We compare MYGA rates across 90+ carriers and can map out a ladder that keeps each rung separate for tax purposes. Request a Quote or a Free Policy Review, or Call Now at 855-277-8088. We’ll show you how your annuity withdrawals are taxed, rung by rung, before you buy.

FAQ

What is a MYGA ladder?

A MYGA ladder spreads your money across several multi-year guaranteed annuities with different terms, so a portion matures every year or two. It reduces the risk of renewing everything at a bad moment for rates.

Does this work for IRA annuities?

No. Withdrawals from a qualified annuity are generally fully taxable no matter how many contracts you hold. The LIFO advantage applies to non-qualified annuities bought with after-tax money.

Can I buy several MYGAs from the same company?

Yes, but contracts from the same insurer (or its affiliates) issued in the same calendar year are taxed as one. To get the separate-contract benefit, use different carriers or different years.

What happens when a rung matures?

You typically get a short window to withdraw, renew, or move the money to another annuity through a 1035 exchange. Cashing out a matured rung returns your principal tax-free along with the taxable gain.

How are annuity withdrawals taxed?

Withdrawals from a non-qualified annuity are taxed gain-first: every dollar counts as ordinary income until the contract’s earnings are used up, and only then does tax-free principal come back. Withdrawals from an IRA annuity are generally fully taxable. Owning several separate contracts lets you cash out one completely and recover its principal, which cut our client’s taxable income on a $40,000 withdrawal to $15,000.

This article is for general education and is not tax advice. Talk with a tax professional about your situation.