Tax Implications of Annuities: What You Should Know

26 May 2025

Annuities can be a fantastic way to secure a steady income during retirement, but let’s be real—nobody likes dealing with taxes. If you’re considering an annuity, you’ll want to know exactly how Uncle Sam will take his share.

The good news? Annuities offer tax-deferred growth, meaning you won’t pay taxes on earnings until you withdraw your funds. The bad news? The tax treatment can get a bit tricky, depending on how you set up your annuity.

So, let’s break it down in plain English: how do annuities impact your taxes, and what can you do to keep more of your hard-earned money?

How Are Annuities Taxed?

An annuity is a financial product that provides a stream of income, typically in retirement. But before you start dreaming of a luxurious retirement with endless vacations, let’s talk taxes.

The way annuities are taxed depends on:

- How you funded it: Did you use pre-tax or after-tax dollars?
- How you withdraw money: Lump sum or periodic payments?
- The type of annuity: Is it a qualified or non-qualified annuity?

Each of these factors plays a role in determining how much you’ll owe to the IRS.

Qualified vs. Non-Qualified Annuities

Taxation of annuities depends heavily on their classification:

Qualified Annuities

A qualified annuity is one that’s purchased with pre-tax dollars—typically through retirement accounts like a 401(k) or IRA. Since you didn’t pay taxes on the money going in, you will pay ordinary income tax on withdrawals, including both principal and earnings.

The downside? There’s no special tax break on withdrawals. Every dollar you pull out is taxed as regular income, meaning it could push you into a higher tax bracket.

Non-Qualified Annuities

A non-qualified annuity is purchased with after-tax dollars—meaning you’ve already paid taxes on the initial investment. The good news? You won’t owe taxes on your principal again.

However, any earnings or interest on your annuity will be taxed as ordinary income upon withdrawal. Unlike capital gains tax (which is typically lower), annuity earnings don’t enjoy any preferential tax treatment.

How Are Withdrawals Taxed?

Let’s say you’re ready to start pulling money from your annuity—how much will you owe in taxes? That depends on two things:

- The method of withdrawal
- Your annuity type (qualified vs. non-qualified)

Let’s break it down further.

Lump-Sum Withdrawals

If you withdraw your entire annuity in one go, you could face a hefty tax bill. Not only will your earnings be taxed as ordinary income, but a large withdrawal might push you into a higher tax bracket.

Periodic Payments (Annuitization)

When you choose to receive payments over time, your tax liability gets spread out. With a non-qualified annuity, each payment consists of two parts:

1. A portion of your original investment (tax-free)
2. A portion of earnings (taxable as ordinary income)

This is where the exclusion ratio comes in: the IRS determines what percentage of each payment is taxable versus tax-free.

Early Withdrawals and Tax Penalties

Need to tap into your annuity before the age of 59½? Be prepared for some tough love from the IRS.

Here’s what happens if you withdraw early:

1. Ordinary Income Tax – Any earnings withdrawn will be taxed at your regular income tax rate.
2. 10% Early Withdrawal Penalty – If you’re under 59½, you’ll get hit with an extra 10% penalty on top of your regular tax bill.

Exceptions exist (such as disability or certain qualified expenses), but for most people, pulling money out early is an expensive mistake.

Taxes on Annuity Death Benefits

What happens to your annuity when you pass away? Well, the IRS doesn’t just forget about taxes.

Beneficiaries and Taxation

- If the annuity owner dies before annuitization, the beneficiary may receive the contract’s value, but the earnings portion will be subject to income tax.
- If payments had already started, the beneficiary will continue receiving payments, taxed at the same rate as the original owner.

Unlike some other investments, annuities do not provide a step-up in basis—meaning beneficiaries will owe taxes on earnings.

Want to leave more to your loved ones? Proper estate planning can help minimize the tax burden.

Tax-Free 1035 Exchanges

What if you want to change annuities without triggering a tax bill? The IRS allows something called a 1035 exchange, which lets you transfer money from one annuity to another tax-free.

Why would you want to do this? A few reasons:

✔️ Switching to an annuity with lower fees
✔️ Getting better investment options
✔️ Locking in more favorable terms

Just make sure you follow the IRS rules, or you might end up with an unexpected tax bill.

Strategies to Minimize Annuity Taxes

Nobody enjoys giving money to the IRS, so let’s talk about some smart ways to reduce your tax burden.

1. Delay Withdrawals for Tax-Deferred Growth

Since annuities grow tax-deferred, keeping your money in the account as long as possible allows it to compound without immediate tax consequences.

2. Use a Roth IRA Conversion

If you have a qualified annuity, consider rolling it into a Roth IRA. You’ll pay taxes upfront, but any future growth and withdrawals will be tax-free.

3. Withdraw Smartly to Avoid Higher Tax Brackets

Since annuity withdrawals are taxed as ordinary income, taking large lump sums might push you into a higher bracket. Spread your withdrawals over time to stay in a lower tax bracket.

4. Consider a Life Insurance Strategy

Some investors use life insurance policies as a tax-efficient way to build wealth for heirs. Unlike annuities, life insurance payouts are typically tax-free for beneficiaries.

5. Work with a Tax Professional

When it comes to taxes, the rules can be complicated. A financial advisor or tax professional can help you structure your withdrawals to minimize taxes and maximize your income.

Final Thoughts

Annuities can be a solid financial tool for retirement, offering stability and guaranteed income. But taxes? Well, they can quickly eat away at your returns if you're not careful.

Understanding how annuities are taxed—whether qualified or non-qualified—allows you to make smarter financial moves and keep more of your money.

Before making any big decisions, it’s always a good idea to consult a tax professional. With the right strategy, you can enjoy your retirement income without handing over too much to the IRS.