Are Annuities Payments Taxable?

• Are annuities taxable is a question we are often asked by our clients. Gain from an annuity is taxed as ordinary income but beyond that annuity taxation varies based on a number of variables.

Annuities receive tax preferred treatment from the IRS because they are designed to be long-term retirement savings vehicles. Tax rules for annuities vary based on the type of annuity and how you ultimately take your money out.

In this, “are annuities taxable?” guide we will go explain how annuities are taxed based on the funds you use to purchase an annuity as well as how annuity income is taxed based on the each particular income option.

Annuities accumulate interest tax-deferred. Tax-deferral means you don’t pay taxes on the interest you earn until you take your money out. If you earn interest in a vehicle that doesn’t grow tax-deferred; such as a CD, you pay taxes on any interest you earn the year in which it is earned regardless if you take it out or not.

Are Annuities Taxable: Key Considerations

The deciding factor on how your annuity will be taxed depends ultimately on the money you used to buy it. Whenever a client asks us how are annuities taxed, our first response is where did you get the money to buy it?

Since we are talking about taxes there is no way to say with

<!– Main Article Section –>
<section>
<h1>How Are Annuities Taxed? Understanding Annuity Taxation Rules</h1>
<p>Annuities are a popular retirement planning tool, offering guaranteed income and tax-deferred growth. But understanding how annuities are taxed is crucial for your retirement income strategy. This guide breaks down key annuity tax rules, when you owe taxes, and what to watch out for with the IRS.</p>
</section>

<section>
<h2>What Is an Annuity?</h2>
<p>An annuity is a contract between you and an insurance company. In exchange for a lump sum or a series of payments, the insurer promises regular income—often for life. There are fixed, variable, and indexed annuities, each with unique features and tax considerations.</p>
</section>

<section>
<h2>Annuity Taxation Basics</h2>
<p>The main tax advantage of annuities is tax-deferred growth. You won’t pay taxes on earnings until you withdraw money or begin receiving payments. Taxation depends on:</p>
<ul>
<li>Type of annuity (Qualified vs. Non-Qualified)</li>
<li>How you funded the annuity</li>
<li>When you take distributions</li>
</ul>
</section>

<section>
<h2>Qualified vs. Non-Qualified Annuities</h2>
<h3>Qualified Annuities</h3>
<p>Purchased with pre-tax dollars, usually through IRAs or 401(k)s. All withdrawals are fully taxable as ordinary income.</p>
<h3>Non-Qualified Annuities</h3>
<p>Funded with after-tax dollars. Only the earnings portion of withdrawals is taxable; your original contributions are not taxed again.</p>
</section>

<section>
<h2>How Are Annuity Withdrawals Taxed?</h2>
<h3>Non-Qualified Annuities</h3>
<p>Withdrawals follow the “last in, first out” (LIFO) rule: earnings come out first and are taxed as ordinary income. Once all earnings are withdrawn, the principal is tax-free.</p>
<h3>Qualified Annuities</h3>
<p>All withdrawals are taxed as ordinary income, since they are funded with pre-tax dollars.</p>
</section>

<section>
<h2>Taxation During the Payout Phase</h2>
<p>When you annuitize and start receiving payments, each payment is split between taxable earnings and non-taxable return of principal (for non-qualified annuities). The insurance company calculates an “exclusion ratio” to determine the taxable portion.</p>
</section>

<section>
<h2>Early Withdrawal Penalties</h2>
<p>If you withdraw funds before age 59½, you may face a 10% early withdrawal penalty on the taxable portion, plus regular income taxes. Some exceptions apply, such as disability or certain qualified plans.</p>
</section>

<section>
<h2>Required Minimum Distributions (RMDs)</h2>
<p>For qualified annuities in IRAs or retirement accounts, you must start taking RMDs at age 73. Failing to take RMDs can result in significant tax penalties.</p>
</section>

<section>
<h2>Taxation at Death: Beneficiary Considerations</h2>
<p>Beneficiaries may owe taxes on untaxed earnings. Lump-sum payouts are generally fully taxable on the earnings, while installment payments may be partially taxable, depending on the exclusion ratio.</p>
</section>

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<section class=”callout-key-takeaways” style=”background: #f7f9fa; border-left: 5px solid #005b94; padding: 1em; margin: 2em 0;”>
<h2 style=”color:#005b94;”>Key Takeaways</h2>
<ul>
<li><strong>Tax-Deferred Growth:</strong> Annuities grow tax-deferred until you take withdrawals.</li>
<li><strong>Earnings Are Taxed as Ordinary Income:</strong> Both qualified and non-qualified annuity earnings are taxed at your regular income tax rate.</li>
<li><strong>Principal May Be Tax-Free:</strong> For non-qualified annuities, your original investment is not taxed again.</li>
<li><strong>Early Withdrawals May Trigger Penalties:</strong> Avoid taking money out before age 59½ unless you qualify for an exception.</li>
<li><strong>RMDs Apply to Qualified Annuities:</strong> Be aware of required minimum distribution rules if your annuity is in a retirement account.</li>
</ul>
</section>

<!– FAQ Section (with basic HTML for Elementor Accordion/Toggle Widget) –>
<section>
<h2>Frequently Asked Questions About Annuity Taxation</h2>
<!– If using Elementor, use the Accordion widget and paste each Q&A below as an item –>
<div class=”faq”>
<h3>Are annuity payments taxed as ordinary income or capital gains?</h3>
<p>Annuity payments are typically taxed as ordinary income, not capital gains. The portion representing earnings is taxed at your regular income rate, while the return of your original investment is not taxed for non-qualified annuities.</p>
</div>
<div class=”faq”>
<h3>When do I have to pay taxes on my annuity?</h3>
<p>You pay taxes on annuity earnings when you withdraw funds or begin receiving payments. Until then, your annuity grows tax-deferred.</p>
</div>
<div class=”faq”>
<h3>Do I pay taxes on my initial investment in a non-qualified annuity?</h3>
<p>No, you do not pay taxes again on your initial investment in a non-qualified annuity. Only the earnings portion of withdrawals is taxable.</p>
</div>
<div class=”faq”>
<h3>What happens if I take money out of my annuity before age 59½?</h3>
<p>If you withdraw funds before age 59½, you may owe a 10% early withdrawal penalty on the taxable portion, plus regular income taxes, unless you qualify for an exception.</p>
</div>
<div class=”faq”>
<h3>How are annuities taxed when passed on to beneficiaries?</h3>
<p>Beneficiaries generally pay income tax on the earnings portion of inherited annuities. Lump-sum payouts are fully taxable on the earnings, while installment payments may be partially taxable depending on the exclusion ratio.</p>
</div>
</section>

<!– Citations Section –>
<section>
<h2>Sources & Further Reading</h2>
<ul>
<li><a href=”https://www.irs.gov/taxtopics/tc410″ target=”_blank” rel=”noopener”>IRS: Tax Topic No. 410 Pensions and Annuities</a></li>
<li><a href=”https://www.finra.org/investors/investing/investment-products/annuities/annuities-what-you-should-know” target=”_blank” rel=”noopener”>FINRA: Annuities – What You Should Know</a></li>
<li><a href=”https://www.investopedia.com/are-annuities-taxable-8636650″ target=”_blank” rel=”noopener”>Investopedia: Are Annuities Taxable?</a></li>
<li><a href=”https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities” target=”_blank” rel=”noopener”>SEC: Variable Annuities</a></li>
</ul>
</section>

<!– Interactive Idea: Progress Bar for Annuity Tax Knowledge (for Elementor) –>
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<section>
<h2>Test Your Annuity Tax Knowledge!</h2>
<p>Want to see how much you know? Use our interactive quiz below or contact us for a personal review.</p>
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exactly how your annuity will be taxed. Tax laws and tax rates can and do change all the time.

However, we can make very educated guesses about certain scenarios based upon how annuities have been and are taxed currently. First we will look at the types of funds you can use to purchase an annuity and explain the differences in how they are taxed.

Roth IRA Annuity Taxation

If you purchase an annuity with funds from a Roth individual retirement account (IRA) or Roth 401(k) it is very likely you won’t have to pay federal income tax at all on the money when you withdraw it from your annuity. That includes the principal and interest.

Are Qualified Annuities Taxed?

Firstly, an annuity purchased with qualified funds is considered a qualified annuity. Qualified funds are monies that you have never paid taxes on such as a traditional IRA or a traditional 401(k). It would be nice if the IRS would allow to go from tax-deferred to tax-free but that is not the case.

When you begin to take withdraws from a qualified annuity you will pay normal federal income taxes. Meaning, 100% your annuity is treated as ordinary income and 100% of the funds will be taxed when they are taken.

Are Non-Qualified Annuities taxed?

A non-qualified annuity is any annuity purchased with after tax-dollars such as money from a taxable personal savings or checking account or a personal brokerage account.

If you own a non-qualified annuity, you will only pay income tax on the gain in your contract but not the money you used to purchase the annuity. The money used to purchase a non-qualified annuity is considered the “basis”. Insurance companies keep track of your “cost-basis” which is the original amount used to purchase an investment.

This “cost-basis” is the amount of money on which you will not pay taxes because you’ve already taxes on it once. The interest earned will be taxed as ordinary income, with a few exceptions that we will discuss momentarily.

Income Annuity Taxation

• Fixed annuities
• Fixed Index Annuities (FIA)
• Variable Annuities (VA)
• Registered Index Linked Annuities (RILA)
• Income annuities

There are really two types of income annuity payout options: lifetime or period certain. A lifetime annuity is an annuity that guarantees payments for as long as you are alive whereas a period-certain annuity guarantees payments for a specified period of time.

Remember, if you own a non-qualified annuity you only pay taxes on the interest earned not the original cost basis. So to determine what portion of your monthly payments are taxable there is a calculation that needs to be done to establish what percent of each annuity is principal (or cost-basis) and what percent is interest earned.

These calculations establish your exclusion ratio, or in plain terms, the percent of each annuity payment that is exempt from income taxes. The method of determining the exclusion ratio varies depending on whether you have a period of a certain annuity or a lifetime annuity. Let’s look at an example for each.

How is a Period Certain Annuity Taxed?

Let’s assume you purchased a 10-year period certain income annuity for $200,000 with non-qualified money that pays you $24,000 per year. In total, you will receive $24,000 times for 10 years for a total of $240,000. You would be then liable for taxes on the $40,000 which is your expected return or the interest your will have earned.

Now you need to take the $40,000 and divide it by 120 which is the total number of monthly payments you will receive over the 10-year period. $40,000 divided by 120 equals $333.33. That is the amount of each monthly $2000 payment that will be taxed as income.

In this scenario the taxable portion of each payment ($333.33) is 13% of the total payment so your exclusion ratio is 87%. The 87%, in this case, $1740,67, is the amount of each payment that will not be taxed.

How Are Lifetime Annuities Taxed?

Let’s assume you purchase a lifetime income annuity at age 65 and based on the life expectancy tables you will live to be 85. The IRS will assume you will receive payments for 20 years when calculating your exclusion ratio. If you purchased a lifetime annuity for $200,000 that paid you 1,167 per month ($14,000 annually), for tax purposes it would be assumed you will receive a total of $280,000 ($14K X 20 years).

Than $80,000 of the $280,000, total payments will be taxable. Since you are expected to receive 240 monthly payments the amount of each payment that is taxed is again $333.33 ($80,000 divided by 240 equals $333.33).

$333.33 of each $1,167 monthly payment would be taxable which equates to 28.6%. In this example, your exclusion ratio is 71.4% meaning 71.4%(or 833.67) of each monthly payment is excluded from taxes.

In Summary: How Are Annuities Taxed?

• Withdraws from Roth Annuity- not taxable

• Withdraws from a non-qualified annuity – gains are taxed

• Withdraws from a qualified annuity – 100% tax

• Income annuities payments are taxed

<!– Main Article Section –>
<section>
<h1>How Are Annuities Taxed? Understanding Annuity Taxation Rules</h1>
<p>Annuities are a popular retirement planning tool, offering guaranteed income and tax-deferred growth. But understanding how annuities are taxed is crucial for your retirement income strategy. This guide breaks down key annuity tax rules, when you owe taxes, and what to watch out for with the IRS.</p>
</section>

<section>
<h2>What Is an Annuity?</h2>
<p>An annuity is a contract between you and an insurance company. In exchange for a lump sum or a series of payments, the insurer promises regular income—often for life. There are fixed, variable, and indexed annuities, each with unique features and tax considerations.</p>
</section>

<section>
<h2>Annuity Taxation Basics</h2>
<p>The main tax advantage of annuities is tax-deferred growth. You won’t pay taxes on earnings until you withdraw money or begin receiving payments. Taxation depends on:</p>
<ul>
<li>Type of annuity (Qualified vs. Non-Qualified)</li>
<li>How you funded the annuity</li>
<li>When you take distributions</li>
</ul>
</section>

<section>
<h2>Qualified vs. Non-Qualified Annuities</h2>
<h3>Qualified Annuities</h3>
<p>Purchased with pre-tax dollars, usually through IRAs or 401(k)s. All withdrawals are fully taxable as ordinary income.</p>
<h3>Non-Qualified Annuities</h3>
<p>Funded with after-tax dollars. Only the earnings portion of withdrawals is taxable; your original contributions are not taxed again.</p>
</section>

<section>
<h2>How Are Annuity Withdrawals Taxed?</h2>
<h3>Non-Qualified Annuities</h3>
<p>Withdrawals follow the “last in, first out” (LIFO) rule: earnings come out first and are taxed as ordinary income. Once all earnings are withdrawn, the principal is tax-free.</p>
<h3>Qualified Annuities</h3>
<p>All withdrawals are taxed as ordinary income, since they are funded with pre-tax dollars.</p>
</section>

<section>
<h2>Taxation During the Payout Phase</h2>
<p>When you annuitize and start receiving payments, each payment is split between taxable earnings and non-taxable return of principal (for non-qualified annuities). The insurance company calculates an “exclusion ratio” to determine the taxable portion.</p>
</section>

<section>
<h2>Early Withdrawal Penalties</h2>
<p>If you withdraw funds before age 59½, you may face a 10% early withdrawal penalty on the taxable portion, plus regular income taxes. Some exceptions apply, such as disability or certain qualified plans.</p>
</section>

<section>
<h2>Required Minimum Distributions (RMDs)</h2>
<p>For qualified annuities in IRAs or retirement accounts, you must start taking RMDs at age 73. Failing to take RMDs can result in significant tax penalties.</p>
</section>

<section>
<h2>Taxation at Death: Beneficiary Considerations</h2>
<p>Beneficiaries may owe taxes on untaxed earnings. Lump-sum payouts are generally fully taxable on the earnings, while installment payments may be partially taxable, depending on the exclusion ratio.</p>
</section>

<!– Key Takeaways Callout Section –>
<section class=”callout-key-takeaways” style=”background: #f7f9fa; border-left: 5px solid #005b94; padding: 1em; margin: 2em 0;”>
<h2 style=”color:#005b94;”>Key Takeaways</h2>
<ul>
<li><strong>Tax-Deferred Growth:</strong> Annuities grow tax-deferred until you take withdrawals.</li>
<li><strong>Earnings Are Taxed as Ordinary Income:</strong> Both qualified and non-qualified annuity earnings are taxed at your regular income tax rate.</li>
<li><strong>Principal May Be Tax-Free:</strong> For non-qualified annuities, your original investment is not taxed again.</li>
<li><strong>Early Withdrawals May Trigger Penalties:</strong> Avoid taking money out before age 59½ unless you qualify for an exception.</li>
<li><strong>RMDs Apply to Qualified Annuities:</strong> Be aware of required minimum distribution rules if your annuity is in a retirement account.</li>
</ul>
</section>

<!– FAQ Section (with basic HTML for Elementor Accordion/Toggle Widget) –>
<section>
<h2>Frequently Asked Questions About Annuity Taxation</h2>
<!– If using Elementor, use the Accordion widget and paste each Q&A below as an item –>
<div class=”faq”>
<h3>Are annuity payments taxed as ordinary income or capital gains?</h3>
<p>Annuity payments are typically taxed as ordinary income, not capital gains. The portion representing earnings is taxed at your regular income rate, while the return of your original investment is not taxed for non-qualified annuities.</p>
</div>
<div class=”faq”>
<h3>When do I have to pay taxes on my annuity?</h3>
<p>You pay taxes on annuity earnings when you withdraw funds or begin receiving payments. Until then, your annuity grows tax-deferred.</p>
</div>
<div class=”faq”>
<h3>Do I pay taxes on my initial investment in a non-qualified annuity?</h3>
<p>No, you do not pay taxes again on your initial investment in a non-qualified annuity. Only the earnings portion of withdrawals is taxable.</p>
</div>
<div class=”faq”>
<h3>What happens if I take money out of my annuity before age 59½?</h3>
<p>If you withdraw funds before age 59½, you may owe a 10% early withdrawal penalty on the taxable portion, plus regular income taxes, unless you qualify for an exception.</p>
</div>
<div class=”faq”>
<h3>How are annuities taxed when passed on to beneficiaries?</h3>
<p>Beneficiaries generally pay income tax on the earnings portion of inherited annuities. Lump-sum payouts are fully taxable on the earnings, while installment payments may be partially taxable depending on the exclusion ratio.</p>
</div>
</section>

<!– Citations Section –>
<section>
<h2>Sources & Further Reading</h2>
<ul>
<li><a href=”https://www.irs.gov/taxtopics/tc410″ target=”_blank” rel=”noopener”>IRS: Tax Topic No. 410 Pensions and Annuities</a></li>
<li><a href=”https://www.finra.org/investors/investing/investment-products/annuities/annuities-what-you-should-know” target=”_blank” rel=”noopener”>FINRA: Annuities – What You Should Know</a></li>
<li><a href=”https://www.investopedia.com/are-annuities-taxable-8636650″ target=”_blank” rel=”noopener”>Investopedia: Are Annuities Taxable?</a></li>
<li><a href=”https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/variable-annuities” target=”_blank” rel=”noopener”>SEC: Variable Annuities</a></li>
</ul>
</section>

<!– Interactive Idea: Progress Bar for Annuity Tax Knowledge (for Elementor) –>
<!–
<section>
<h2>Test Your Annuity Tax Knowledge!</h2>
<p>Want to see how much you know? Use our interactive quiz below or contact us for a personal review.</p>
<!– Suggestion: Use Elementor’s Progress Bar or Quiz Widget here! –>
<!–</section>
–>