Annuities are often marketed as "tax-advantaged" products, and in a narrow sense, that is accurate. But the tax treatment of annuities is more nuanced than the phrase suggests, and misunderstanding it can lead to some genuinely unpleasant surprises at tax time.
The core rule is simple: annuities are not taxed while they grow, but they are taxed when you take money out.1 Everything else, how much is taxed, when, and at what rate, depends on how the annuity was funded, how you take distributions, and whether the contract is held inside or outside a retirement account.
Qualified vs. Non-Qualified: The Most Important Distinction
The first question that determines how your annuity is taxed is whether it is a "qualified" or "non-qualified" annuity.
A qualified annuity is one purchased with pre-tax dollars, typically inside an IRA, 401(k), or other tax-advantaged retirement plan. Because you received a tax deduction (or tax deferral) when the money went in, the IRS treats every dollar that comes out as taxable income. There is no "basis" to recover, because you never paid taxes on the original contribution.1
A non-qualified annuity is purchased with after-tax dollars, outside of a retirement account. You already paid income tax on the money before it went into the contract. As a result, only the earnings portion of your withdrawals is taxable. Your original investment (your "cost basis") comes back to you tax-free.1
This distinction matters enormously for planning. A $500,000 qualified annuity that you withdraw from over 20 years generates $500,000 of fully taxable income. A $500,000 non-qualified annuity where $300,000 is your original after-tax investment generates only $200,000 of taxable income over the same period.
The LIFO Rule: How Non-Qualified Withdrawals Are Taxed
For non-qualified annuities, the IRS applies a "last-in, first-out" (LIFO) rule to partial withdrawals.2
Under LIFO, the IRS treats your withdrawals as coming from earnings first, not from your original investment. You do not get to access your tax-free basis until you have withdrawn every dollar of gain.
An example makes this concrete. Suppose you invested $100,000 in a non-qualified annuity and it has grown to $160,000. You have $60,000 in earnings and $100,000 in basis. If you take a $30,000 partial withdrawal, the IRS treats the entire $30,000 as taxable earnings, not as a partial return of your basis. You would owe ordinary income tax on the full $30,000.
This is different from how other investments work. If you sold $30,000 worth of stock in a taxable brokerage account, you would pay tax only on the gain embedded in those shares, not on the full amount. The LIFO rule makes annuity withdrawals less tax-efficient than many people expect.
The LIFO rule applies to partial withdrawals. It does not apply when you fully annuitize the contract, which is where the exclusion ratio comes in.
The Exclusion Ratio: Tax Efficiency Through Annuitization
When you annuitize a non-qualified annuity, converting the accumulated value into a series of regular income payments, the IRS calculates an "exclusion ratio" that determines what portion of each payment is taxable.1
The exclusion ratio is simply your cost basis divided by the total expected payments over your lifetime. The IRS uses actuarial tables to calculate your expected lifetime payments.
Here is how it works in practice. Suppose you have a non-qualified annuity with $100,000 in basis (your original after-tax investment) and $100,000 in earnings, for a total value of $200,000. You annuitize, and based on your age and the payment amount, the IRS calculates that you will receive $200,000 in total payments over your expected lifetime. Your exclusion ratio is 50% ($100,000 basis divided by $200,000 total expected payments). That means 50% of each payment is treated as a tax-free return of principal, and 50% is taxable as ordinary income.
This continues until you have fully recovered your basis. After that point, all remaining payments are fully taxable.1
For many retirees, annuitization produces a more tax-efficient income stream than taking partial withdrawals subject to the LIFO rule, particularly when the annuity has significant accumulated gains.
Qualified Annuities and Required Minimum Distributions
If your annuity is held inside a traditional IRA or other qualified plan, it is subject to required minimum distribution (RMD) rules. Starting at age 73 (under current law following the SECURE 2.0 Act), you must begin taking minimum distributions from qualified accounts each year, whether or not you need the income.3
This applies to annuities inside IRAs just as it applies to mutual funds or stocks inside IRAs. If the annuity has a surrender period and you need to take an RMD that exceeds the contract's free withdrawal allowance, you may face surrender charges. This is an important planning consideration when purchasing a deferred annuity inside an IRA.
One exception: a Qualified Longevity Annuity Contract (QLAC) allows you to use up to $200,000 from your IRA to purchase a deferred income annuity that begins payments at a future date (up to age 85), and those funds are excluded from RMD calculations until the income start date.3 This can be a useful tool for managing RMD exposure while guaranteeing income later in life.
The 10% Early Withdrawal Penalty
Like IRAs and 401(k)s, annuities carry a 10% federal penalty on withdrawals taken before age 59½, in addition to ordinary income taxes on the taxable portion.1
For a non-qualified annuity, the penalty applies only to the earnings portion of the withdrawal (since your basis is not taxable). For a qualified annuity, the penalty applies to the full amount.
There are exceptions. Withdrawals due to death or disability, and certain structured lifetime income payments (called "substantially equal periodic payments" or SEPP under IRS Section 72(t)), can avoid the penalty. But these exceptions are narrow and must meet specific IRS requirements.
The 1035 Exchange: Switching Annuities Without a Tax Bill
If you own an annuity with significant accumulated gains and you want to move to a different product (perhaps one with lower fees, better terms, or different features), you can do so without triggering a taxable event through a Section 1035 exchange.4
A 1035 exchange allows you to transfer the value of one annuity directly to another annuity, tax-free. The key requirements are that the transfer must be direct (from carrier to carrier, not through you), and the new contract must be a "like-kind" product (annuity to annuity, or life insurance to annuity, but not annuity to life insurance).4
Your original cost basis carries over to the new contract. The accumulated gains remain tax-deferred in the new annuity. No taxes are owed at the time of the exchange.
This is an important planning tool for people who own older, higher-cost annuities and want to upgrade to a more competitive product. The 1035 exchange eliminates the tax barrier to making that switch.
How Inherited Annuities Are Taxed
When an annuity owner dies, the tax treatment of the death benefit depends on the type of annuity and the relationship of the beneficiary to the owner.
For non-qualified annuities, beneficiaries owe ordinary income tax on the earnings portion of any death benefit they receive. Unlike stocks or real estate, annuities do not receive a step-up in cost basis at death. The beneficiary inherits the original owner's cost basis, and all gains above that basis are taxable as ordinary income when distributed.5
For qualified annuities (held inside an IRA), the SECURE Act rules generally require non-spouse beneficiaries to fully distribute the inherited account within 10 years of the owner's death, with all distributions taxed as ordinary income.6
A surviving spouse has more flexibility. A spouse can roll over an inherited annuity into their own IRA or continue the contract as the new owner, deferring taxes until they take distributions.
The absence of a step-up in basis is one of the most significant tax disadvantages of annuities compared to taxable investment accounts. For clients with large non-qualified annuity gains who are focused on estate planning, this is a meaningful consideration.
The Bottom Line on Annuity Taxes
Annuities offer genuine tax deferral during the accumulation phase, which can be valuable, particularly for high-income earners who have exhausted other tax-advantaged accounts. But the tax treatment at distribution is less favorable than many people realize: all gains come out as ordinary income, not at capital gains rates; the LIFO rule front-loads the tax burden on partial withdrawals; and there is no step-up in basis at death.
Understanding these rules before you purchase, and before you start taking distributions, is the difference between a tax-efficient retirement income strategy and an unnecessarily large tax bill.
References
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Footnotes
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Annuity.org. "How Are Annuities Taxed? Rules for Withdrawals, Income & Growth." Updated February 2026. https://www.annuity.org/annuities/taxation/ ↩ ↩2 ↩3 ↩4 ↩5 ↩6
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PlanEasy. "How Are Non-Qualified Annuities Taxed? LIFO vs. Exclusion Ratio." January 19, 2026. https://planeasy.com/articles/how-are-non-qualified-annuities-taxed ↩
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IRS. "Topic No. 410, Pensions and Annuities." Updated February 24, 2026. https://www.irs.gov/taxtopics/tc410 ↩ ↩2
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Gainbridge. "What Is a 1035 Exchange?" May 23, 2025. https://gainbridge.com/post/what-is-a-1035-exchange ↩ ↩2
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Asset Preservation Strategies. "How Are Annuities Taxed at Death." April 10, 2025. https://www.apsitaxes.com/blog/how-annuities-taxed-at-death ↩
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Thrivent. "You have Inherited an Annuity. Now What?" January 27, 2025. https://www.thrivent.com/insights/annuities/youve-inherited-an-annuity-now-what ↩