How Are Fixed Index Annuities Taxed? (2026 Guide)

Last updated: April 12, 2026  |  By Jason Caudill, MBA  |  Reviewed by the MyAnnuityStore Editorial Team

How Are Fixed Index Annuities Taxed?

Fixed index annuities grow tax-deferred, meaning you pay no taxes on gains while money stays inside the contract. When you take a withdrawal, the IRS taxes your earnings as ordinary income, not capital gains. The order in which money comes out, and whether you owe a 10% penalty, depends on how your contract is structured and when you take distributions.

This page covers every tax rule that applies to FIAs: tax-deferred growth, the LIFO rule, the 10% early withdrawal penalty, the difference between qualified and non-qualified contracts, 1035 exchanges, and inherited annuity rules for beneficiaries.

Tax-Deferred Growth: The Primary FIA Tax Benefit

Every dollar of index credits earned inside a fixed index annuity compounds without being taxed each year. This is the feature that separates an FIA from a CD or savings account.

A bank CD generates a 1099-INT every year. You pay ordinary income tax on interest even if you never touched the money. An FIA earns index credits each contract year but produces no 1099 until you take a distribution. Over a 10-year contract, the difference between paying taxes annually versus deferring them compounds significantly.

Example: David, age 58, deposits $200,000 into a 10-year FIA. His contract earns an average of 6% annually through index credits. At maturity, his account value has grown to approximately $358,000. He has paid no taxes on any of those gains during the 10 years. When he begins taking withdrawals at 68, he pays ordinary income tax on the $158,000 of earnings spread across his retirement years, not as a lump sum.

The LIFO Rule: How Withdrawals Are Taxed on Non-Qualified FIAs

On non-qualified annuities (funded with after-tax money, not from an IRA), the IRS applies the LIFO rule. LIFO stands for Last In, First Out. Your earnings are considered to come out of the contract before your original principal.

Every dollar you withdraw is taxable as ordinary income until you have withdrawn all accumulated gains. Only then does the IRS treat subsequent withdrawals as a return of your original cost basis, which is tax-free.

Example: Karen deposited $150,000 into a non-qualified FIA. Her contract grew to $210,000, giving her $60,000 in accumulated gains. She takes a $30,000 withdrawal. Under LIFO, the entire $30,000 is taxable because her gains ($60,000) exceed her withdrawal amount. She owes ordinary income tax on the full $30,000.

The LIFO rule is one reason many FIA holders defer withdrawals until retirement, when their ordinary income tax rate is likely lower than during peak earning years.

The 10% Early Withdrawal Penalty

The IRS charges a 10% penalty on taxable annuity withdrawals taken before age 59 1/2. This penalty is in addition to ordinary income tax. It is not a substitute for it.

Example: Michael, age 55, withdraws $25,000 from a non-qualified FIA. He has more than $25,000 in accumulated gains, so the full amount is taxable under LIFO. He is in the 22% federal bracket. His tax bill on this withdrawal: $5,500 in income tax plus $2,500 in IRS early withdrawal penalty. He nets $17,000 after combined costs on a $25,000 withdrawal.

Exceptions to the 10% penalty:

• Death of the owner. Beneficiaries who inherit an annuity are not subject to the 10% penalty.
• Disability. Must meet the IRS definition of total and permanent disability.
• Substantially Equal Periodic Payments (SEPP). Under IRS section 72(t), you can take a series of substantially equal annual payments from any age without penalty. Once started, these must continue for at least 5 years or until age 59 1/2, whichever is longer.

Important: the surrender charges your insurance carrier imposes and the IRS early withdrawal penalty are completely separate. You can owe both simultaneously if you withdraw during the surrender period before age 59 1/2.

Non-Qualified vs. Qualified FIAs

Whether your FIA is classified as non-qualified or qualified determines how every withdrawal is taxed.

Non-Qualified FIA (after-tax money)

You funded this contract with money that was already taxed. Only the growth inside the contract is taxable on withdrawal. The LIFO rule applies, meaning gains come out first. Your original deposit (cost basis) is eventually returned tax-free.

• No contribution limits
• No Required Minimum Distributions
• Only earnings are taxed on withdrawal
• 10% penalty applies before age 59 1/2

Qualified FIA (IRA or 401k rollover)

You funded this contract with pre-tax dollars rolled over from an IRA, 401k, or other qualified retirement account. Every dollar you withdraw is fully taxable as ordinary income. There is no cost basis distinction because the original money was never taxed.

• Subject to Required Minimum Distributions beginning at age 73 (SECURE 2.0)
• 10% early withdrawal penalty applies before age 59 1/2
• No LIFO distinction. All withdrawals are taxable.
• RMD calculated on full contract value each year

The majority of FIA buyers fund contracts with IRA rollovers. If that describes your situation, plan to pay ordinary income tax on every dollar you withdraw.

Required Minimum Distributions on Qualified FIAs

If your FIA was funded with IRA or 401k money, you must begin taking Required Minimum Distributions at age 73 under SECURE 2.0 rules.

Your carrier calculates the RMD by dividing your account value as of December 31 of the prior year by your IRS life expectancy factor. Most carriers will process this automatically if you set up annual RMD elections. Failing to take an RMD triggers a 25% IRS excise tax on the amount not distributed (reduced to 10% if corrected promptly).

Most FIA contracts allow at least 10% annual free withdrawals, which is usually sufficient to cover RMDs. If your contract value is large or your other IRA balances push your aggregate RMD higher, confirm the free-withdrawal provision covers your requirement before the deadline.

The 1035 Exchange: Replace Your Annuity Without Paying Taxes Now

A 1035 exchange is an IRS provision that allows you to transfer the cash value from one annuity contract directly into another without recognizing the gains as income. Your original cost basis carries into the new contract. You defer the tax, not eliminate it.

This is valuable when you want to move from an older, lower-performing annuity into a newer FIA with better caps, lower fees, or stronger income rider terms. Surrendering the old contract and buying a new one triggers a taxable event in the year of surrender. A properly executed 1035 exchange does not.

Rules for a valid 1035 exchange:

• The transfer must go directly from one insurance company to another. You cannot receive a check and then re-deposit it.
• The receiving contract must be an annuity. You cannot 1035 into a bank account or mutual fund.
• Partial 1035 exchanges are permitted, letting you move only a portion of an old contract.
• Surrender charges from the original carrier may still apply, even on a tax-free 1035.
• Your accumulated gains carry forward. You will still owe taxes on those gains when you eventually take distributions from the new contract.

Inherited FIA: Tax Rules for Beneficiaries

When an FIA owner dies, the tax treatment shifts based on the beneficiary’s relationship to the owner and how the contract was funded.

Spouse inherits

A surviving spouse has the broadest options. They can continue the contract as their own through spousal continuation, maintaining the same tax-deferred status. No immediate distribution is required and no tax is triggered at the time of inheritance.

Non-spouse inherits a non-qualified FIA

Non-spouse beneficiaries must generally distribute the full contract value within 5 years of the owner’s death. Every dollar distributed that exceeds the original cost basis is taxable as ordinary income. The 10% early withdrawal penalty does not apply to inherited annuity distributions, regardless of the beneficiary’s age.

Non-spouse inherits a qualified FIA (IRA-funded)

The SECURE Act (2019) and SECURE 2.0 (2022) require most non-spouse beneficiaries to fully distribute inherited IRA-funded annuities within 10 years. Eligible designated beneficiaries (surviving spouses, minor children of the owner, disabled individuals, chronically ill individuals, and individuals not more than 10 years younger than the owner) may qualify for longer stretch distribution periods.

All distributions from an inherited qualified FIA are fully taxable as ordinary income. The 10% early withdrawal penalty does not apply.

Death benefit riders and taxes

Some FIA contracts include enhanced death benefit riders that pay beneficiaries more than the current account value. The same tax rules apply to enhanced death benefits as to regular account value. Any amount above the original cost basis is taxable to the beneficiary as ordinary income.

Common Tax Mistakes FIA Owners Make

• Missing Required Minimum Distributions. The IRS excise tax for a missed RMD is 25%. Set up automatic annual RMD processing with your carrier before age 73.
• Confusing carrier surrender charges with IRS penalties. These are separate charges from separate authorities. You can owe both simultaneously if you withdraw early and during the surrender period.
• Taking large withdrawals in high-income years. If you have flexibility, delay withdrawals to years when your other income is lower. Ordinary income rates determine what you owe on every FIA distribution.
• Surrendering an old annuity instead of doing a 1035 exchange. Taking a check and buying a new annuity is a fully taxable event in the year of surrender. A 1035 exchange avoids that entirely.
• Assuming beneficiaries can stretch distributions indefinitely. The SECURE Act eliminated most stretch strategies for non-spouse beneficiaries. Plan distributions accordingly to avoid large tax spikes in the distribution year.
• Funding a non-qualified FIA inside a Roth IRA. Placing a tax-deferred annuity inside a Roth IRA provides no additional tax benefit. The annuity’s tax deferral is redundant inside an already tax-free account. The insurance costs still apply, reducing net returns without any offsetting benefit.

Related Resources

• Fixed Index Annuity Complete Guide
• Top 10 Best Fixed Index Annuity Companies
• Participation Rate Crediting Method
• Spread and Margin Crediting Method
• Best FIA with Income Rider
• Current FIA Cap & Participation Rates

Frequently Asked Questions

How are fixed index annuities taxed?

FIA earnings grow tax-deferred inside the contract. When you take withdrawals, gains are taxed as ordinary income, not capital gains. On non-qualified (after-tax) contracts, the LIFO rule means gains come out first. On qualified (IRA-funded) contracts, every dollar withdrawn is fully taxable.

Do you pay taxes on FIA growth every year?

No. Index credits earned inside a fixed index annuity are not reported to the IRS each year. You receive no 1099 on annual gains. Taxes are owed only in the year you take a withdrawal, surrender the contract, or receive a distribution.

What is the LIFO rule on annuities?

LIFO stands for Last In, First Out. On non-qualified annuities, the IRS considers your earnings to come out before your original principal. Every dollar you withdraw is fully taxable as ordinary income until all accumulated gains have been distributed. Only after that point do withdrawals represent a tax-free return of your original deposit.

What is the 10% penalty on annuity withdrawals?

The IRS charges a 10% early withdrawal penalty on taxable distributions from an annuity taken before age 59 1/2. This penalty is charged in addition to regular income tax. Exceptions include death of the contract owner, disability, and substantially equal periodic payments under IRS section 72(t).

Can you do a 1035 exchange into a fixed index annuity?

Yes. A 1035 exchange allows you to transfer funds from an existing annuity directly into a new FIA without triggering a taxable event in the year of transfer. The exchange must go contract-to-contract without you receiving the funds. Your original cost basis carries forward, and gains remain tax-deferred until you take future withdrawals from the new contract.

Who pays taxes on an inherited fixed index annuity?

The beneficiary pays ordinary income tax on any gains distributed from an inherited annuity. Non-spouse beneficiaries of non-qualified FIAs must generally distribute the full contract within 5 years. Non-spouse beneficiaries of qualified (IRA-funded) FIAs must generally distribute within 10 years under SECURE Act rules. The 10% early withdrawal penalty does not apply to inherited annuity distributions regardless of the beneficiary’s age.

Sources & Citations

• IRS Publication 575: Pension and Annuity Income
• IRS: Retirement Plans FAQs Regarding IRAs
• IRS: SECURE 2.0 RMD and Contribution Limit Changes
• NAIC: National Association of Insurance Commissioners
• Annuity.org: Annuity Taxation Explained

Disclosures: Educational information only. Tax laws change; consult a qualified tax professional before making decisions based on this article. This is not legal or tax advice. Guarantees are subject to the claims-paying ability of the issuing insurer.