Understanding Tax Implications of Annuities: What Retirees Need to Know

Retirement is about enjoying the rewards of years of hard work. But for many retirees, financial decisions don’t stop when the paychecks end. Annuities can play a big role in providing a steady income. However, taxes can have a significant impact on how much of that income you actually keep.

According to the Insured Retirement Institute, more than 2.6 million annuity contracts were sold in the U.S. in 2023. Many retirees choose them for guaranteed payments. Yet, surveys show that fewer than half of annuity owners fully understand how those payments are taxed. This lack of knowledge can lead to unpleasant surprises when tax season arrives.

In this article, we’ll break down the basics of annuity taxation. We’ll also explore scenarios most online articles skip over. And we’ll explain why attending educational seminars can help retirees make better decisions.

The Basics of Annuity Tax

The term annuity tax refers to how the IRS treats the money you receive from your annuity. Annuities can be funded in two main ways: with pre-tax dollars or after-tax dollars.

If you purchased the annuity with pre-tax money—such as through a traditional IRA or 401(k)—the entire distribution is taxable. That’s because you didn’t pay tax when you contributed the money.

If you purchased it with after-tax money, only the earnings portion is taxable. The principal you put in was already taxed.

Think of it like slicing a pie. Part of each slice is principal (tax-free) and part is earnings (taxable). The challenge is knowing how big each portion is in your payments.

Breaking Down the Tax Treatment of Annuities

The tax treatment of annuities depends on whether the funds are distributed periodically or all at once.

With periodic payments, the IRS uses the exclusion ratio. This formula determines how much of each payment is taxable. Once you’ve recovered your initial investment, all subsequent payments are taxable.

Lump-sum withdrawals are different. The IRS often applies the Last-In, First-Out (LIFO) rule. This means earnings come out first and are taxed immediately. Only after all earnings are withdrawn will you start receiving your tax-free principal.

Ordinary income tax rates apply. Annuity earnings are not taxed as capital gains, even if the money was invested for many years.

Non Qualified Annuity Tax Treatment — What’s Different?

A non qualified annuity is purchased with after-tax dollars. These are popular for retirees who want extra income outside of their retirement accounts.

With non qualified annuity tax treatment, your principal is not taxed again. Only your earnings are subject to tax.

Withdrawals follow the LIFO rule, so taxable earnings come out before tax-free principal. This can lead to higher tax bills in early years if you make large withdrawals.

One common misconception is that all annuity payments are taxed at the same rate. In reality, the tax depends on whether the payment includes your original investment.

How Tax-Deferred Annuities Can Affect Retirement Income

Tax deferred annuities let your investment grow without paying taxes on earnings until you take withdrawals. This can help your money grow faster over time.

The trade-off is that taxes are simply delayed, not avoided. When you withdraw funds, the earnings are taxed as ordinary income. This can be a shock for retirees in higher tax brackets.

If the annuity is inside a qualified plan, you may also need to take Required Minimum Distributions (RMDs) starting at age 73 (as of 2025). Missing an RMD can lead to a steep IRS penalty—up to 25% of the amount you should have withdrawn.

Tax Scenarios You Won’t Find in Most Guides

Many articles stop at the basics. But annuity taxation can be affected by life changes and less common events. Here are three situations that often get overlooked:

1. Annuities and Relocation

If you move to a different state, your annuity income might be taxed differently. Some states have no income tax. Others exempt part of retirement income. A move could lower or increase your tax bill.

2. Inheritance & Annuities

If your heirs inherit an annuity, the tax treatment depends on the contract terms. Some heirs take a lump sum, triggering immediate taxation of earnings. Others can choose periodic payments, spreading the tax liability over time.

3. Inflation & Tax Impact

Inflation can change the real value of your annuity income. While the nominal amount may stay the same, the purchasing power drops over time. If your tax bracket doesn’t change, you could effectively pay more in real terms.

Speak to Us About Annuity Tax Today

Annuities can be a valuable tool for retirement income. But understanding the tax rules is crucial to keeping more of what you earn.

Remember:

• Pre-tax annuities are fully taxable at withdrawal.
• Non qualified annuities tax only the earnings portion.
• Tax deferral is not tax elimination—plan withdrawals strategically.

Life events like moving, passing assets to heirs, or facing inflation can all affect your tax situation. Staying informed is your best defense against costly surprises.

If you’re a retiree, attend educational seminars to learn more about how annuities fit into your financial plan. Call us right now to speak to an expert!

FAQs

Do you pay taxes on annuities? 

Yes. Taxes apply to the earnings portion of your annuity payments. If the annuity was purchased with pre-tax money, the entire amount is taxable.

How are annuities taxed during retirement? 

Payments are taxed as ordinary income. The taxable portion depends on whether it’s a qualified or non qualified annuity.

What is the tax on annuity income if withdrawn early? 

If you withdraw before age 59½, you may owe a 10% early withdrawal penalty on taxable earnings, in addition to regular income tax.

Can annuity taxes be reduced through strategic withdrawals?

Yes. By spreading withdrawals over several years, you may stay in a lower tax bracket and reduce overall tax liability.

Are annuity payments subject to state income tax?

It depends on your state. Some states tax annuity income fully, others partially, and a few do not tax it at all.

Do inherited annuities have special tax rules?

Yes. Beneficiaries generally pay tax on the earnings portion of inherited annuities, and lump sums may trigger a larger tax bill.

Is the exclusion ratio used for all annuities?

No. The exclusion ratio applies mainly to non qualified annuities with periodic payments. Lump-sum withdrawals follow different rules.

Are annuities taxed as capital gains?

No. All annuity earnings are taxed as ordinary income, even if the funds were invested for many years.

What happens to annuity taxes if I roll over my contract?

If you do a proper 1035 exchange, you can transfer funds from one annuity to another without triggering immediate taxes.

Do I pay taxes on annuity income if I stop receiving payments early?

Yes. Any taxable earnings withdrawn are still subject to ordinary income tax, plus possible early withdrawal penalties if under 59½.