How Are Annuities Taxed? | What You Need to Know

An annuity can provide guaranteed income for the rest of your life. How annuities are taxed depends on the type of contract, how it was funded and how withdrawals are made. Earnings from annuities are generally taxed as ordinary income when withdrawn, while contributions made with after-tax dollars may be partially excluded from taxation.

Consider working with a financial advisor as you navigate retirement planning and tax strategy.

Are Annuities Taxable?

How an annuity is purchased, held, and paid out determines its tax treatment. Broadly speaking, annuities can be classified as either qualified or non-qualified, and that classification is the starting point for how taxes apply.

Qualified Annuities

Qualified annuities are funded with pre-tax dollars, typically within a tax-deferred retirement account such as a traditional IRA or 401(k). Because the contributions were never taxed, the IRS treats the entire amount withdrawn—both the original investment and any earnings—as ordinary income. There are no exclusions or carve-outs for principal. For example, if someone rolls $100,000 from a 401(k) into a qualified annuity and begins receiving $5,000 annually, the full $5,000 is taxable each year, regardless of how much came from growth versus original contributions.

Non-Qualified Annuities

Non-qualified annuities are funded with after-tax dollars, meaning the initial investment has already been taxed. As a result, only the earnings portion of the annuity is subject to tax upon withdrawal, while the principal is returned tax-free. The IRS uses what’s known as the exclusion ratio to split each payout between taxable and non-taxable amounts.

For example, if someone invests $100,000 in a non-qualified annuity that grows to $160,000, the $60,000 in gains is taxable. If the annuity pays out $8,000 per year for 20 years, then $3,000 of each payment would be taxable income, and the remaining $5,000 would be excluded from taxation until the $100,000 principal is fully recovered.

Other Tax Considerations

After this distinction, things can get rather complex. There are varying types of annuities (indexed, variable etc.) and different situations that affect tax liability. Tax laws and rates change often, so it’s hard to predict your situation at the time you begin withdrawals.

In other words, you can’t say for sure what will actually happen when it comes time to take money out of your annuity. However, you can make some educated guesses about common scenarios.

Is Your Annuity Period or Lifetime?

The type of annuity you have may also affect your future tax liability. There are many different varieties, including fixed annuities, variable annuities, immediate annuities and deferred annuities. For this, though, we’ll discuss the most general versions: period annuities and lifetime annuities.

A lifetime annuity pays you a guaranteed regular amount, usually monthly, for as long as you live. A period annuity is one that will provide you with regular payments for a set number of years.

With period annuities, simply multiply the number of payments by the amount of the payments. So if you have a 10-year annuity that will pay you $12,000 a year, you should expect a return 10 times $12,000, or $120,000. That’s your expected return.

If you have a lifetime annuity, that complicates matters slightly. To figure out your tax liability with a lifetime annuity, first estimate how long you’ll live. Multiply your expected remaining years by the size of each annual payment. That gives you your expected return on a lifetime annuity.

Say you have a lifetime annuity that pays $12,000 a year. You are 65, and, according to the IRS longevity table, you’ll live well into your 80s, which is another 20 years. In turn, multiply 20 years by $12,000 and you will get $240,000 for your expected return.

How Income Tax Works for Annuities

Remember the basis—the after-tax money used to purchase a non-qualified annuity—that we spoke about earlier? Well, you can now take the basis and divide it by the expected return. This equation yields the percentage of each payment that will not be taxable. To make things more tangible, multiply the percentage by each payment to find the exact tax-free amount.

For example, say you paid $90,000 for a lifetime annuity with an expected return of $120,000. Dividing the basis ($90,000) by the expected return ($120,000) gives you 75%. Then, by multiplying 75% by the amount of each payment, you’ll see how much of the payment will not incur taxes. So if your $120,000 annuity assumes your life expectancy is 20 years, your monthly payments would be $400. Of that, $300, or 75%, would be tax-free.

This is a much simpler example than what you’ll likely encounter in real life. There are different situations in which you might be subject to more or less taxation. If you outlive the IRS longevity estimate, all annuity payments beyond that age will likely be fully taxable. It may not be a bad idea to consult with a financial advisor. In particular, a tax professional could help you before you buy or take withdrawals from an annuity.

Bottom Line

Tax treatment of annuities depends on how they’re structured, how they were funded, and how long the income lasts. While some of the income may be excluded from taxation—particularly in non-qualified annuities—gains are typically taxed as ordinary income, not capital gains. Estimating future tax liability involves working with assumptions, including life expectancy, payout schedules and how tax laws might change.

Tips for Your Retirement Savings

If you feel you’ve exhausted every option to boost your retirement savings, you might want to consult a financial advisor. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Don’t focus only on the balance of your 401(k), IRA or another retirement savings vehicle. Be sure you don’t forget about Social Security benefits. It would be difficult for most retirees to live solely off of Social Security. But they payments it can be a helpful addition to any savings plan. SmartAsset’s Social Security calculator can help you estimate what you’ll receive.