How Are Annuities Taxed? Qualified vs. Non-Qualified Rules

Key takeaways

Annuity earnings grow tax-deferred and are taxed as ordinary income when they come out, not as capital gains [11][12].
A qualified annuity sits inside an IRA or employer plan, so payouts are usually fully taxable; a non-qualified annuity taxes only the earnings [3][4].
Withdrawals from a non-qualified deferred annuity come out gains first; annuitized payments are split by an exclusion ratio [1][4].
Taxable amounts taken before age 59½ generally face an extra 10% tax unless an exception applies [4].

This guide explains federal income tax rules for both kinds of annuity contracts, with worked examples. It is general information, not tax advice; the right answer for any one contract depends on its terms and the owner’s full return, so check with a CPA or enrolled agent before acting.

How Are Annuities Taxed?

Annuities are taxed when money comes out, not while it grows. The SEC’s Investor.gov says owners pay no tax on interest or investment gains until they withdraw money, receive income payments, or a death benefit is paid [11]. FINRA adds that gains are then taxed at ordinary income rates [12].

How much of each dollar is taxable depends on one question: was the annuity bought with pre-tax or after-tax money?

Qualified annuity. Held inside a traditional IRA, 401(k), 403(b) or similar plan, usually funded with pre-tax dollars. Distributions are taxed as ordinary income unless the owner made nondeductible (after-tax) contributions [3].
Non-qualified annuity. Bought directly from an insurer with after-tax money. The owner’s investment in the contract, roughly the premiums paid, comes back tax-free; only the earnings are taxed [4].

An annuity inside an IRA or 401(k) adds no extra tax deferral, because the account is already tax-deferred, both FINRA and the SEC note [11][12].

Qualified vs. Non-Qualified Annuities at a Glance

The rows that matter most for taxes are funding, what’s taxable on the way out, and whether lifetime required minimum distributions apply.

Feature	Qualified annuity	Non-qualified annuity
Funded with	Usually pre-tax money in an IRA or employer plan [3]	After-tax money [4]
Taxable on payout	Usually the full amount; after-tax contributions come back tax-free [1][3]	Earnings only [4]
Partial withdrawals	Taxed under the account’s rules [3]	Gains first (LIFO) for post-Aug. 13, 1982 investment [1][4]
Annuitized payments	Simplified Method if there’s after-tax cost [1]	Exclusion ratio (General Rule) [1][2]
10% extra tax before 59½	Yes, with § 72(t) exceptions [1][4]	Yes, with § 72(q) exceptions [4]
Lifetime RMDs	Yes, from age 73 [3][7]	No; distribution rules apply only after the owner dies [4]
Contribution limits	The plan’s or IRA’s limits [12]	None set by the tax code; insurers set their own
Tax form	Form 1099-R [6]	Form 1099-R [6]

How Are Qualified Annuities Taxed?

Because contributions to most qualified accounts were never taxed, every dollar paid out is normally taxable. The IRS says traditional IRA distributions are taxed as ordinary income, but if the owner made nondeductible contributions, not all of the distribution is taxable [3].

A tax-sheltered annuity is not a separate product type. It is the IRS name for a 403(b) plan, a retirement plan for employees of public schools and certain 501(c)(3) tax-exempt organizations [10]. Annuities held in a 403(b) follow qualified-plan rules [1].

The Simplified Method for Plan Annuities

When a pension or plan annuity includes after-tax employee contributions, the retiree recovers that cost tax-free using the Simplified Method. It applies to qualified employee plans and 403(b) plans with an annuity starting date after November 18, 1996, if the retiree is under 75 or has fewer than five years of guaranteed payments [1].

The tax-free amount is the cost divided by a set number of monthly payments. For a single-life annuity, the IRS table uses 360 payments at age 55 or under, 310 at 56–60, 260 at 61–65, 210 at 66–70 and 160 at 71 or older [1].

For example, a retiree aged 62 with $26,000 of after-tax contributions divides $26,000 by 260. That gives $100 of each monthly payment tax-free until the $26,000 is recovered.

How Are Non-Qualified Annuity Payments Taxed?

When a non-qualified annuity is annuitized, meaning converted into a stream of payments, each payment is part tax-free return of cost and part taxable earnings. The tax code calls the split the exclusion ratio [4]. The IRS method for figuring it is the General Rule, which commercial annuities must use [1][2].

Exclusion ratio = Investment in the contract ÷ Expected return

Where:

Investment in the contract = premiums paid, minus any tax-free amounts already received, as of the annuity starting date [4].
Expected return = total payments the contract is expected to make. For life annuities, the IRS bases it on actuarial tables in Pub. 939, using the annuitant’s age at the birthday nearest the annuity starting date [2][4].

Exclusion Ratio Example

Maria, 65, pays $120,000 for an immediate income annuity that pays $700 a month for life, with no refund feature. The Pub. 939 Table V multiple for age 65 is 20.0 [2].

Expected return: $700 × 12 × 20.0 = $168,000.
Exclusion ratio: $120,000 ÷ $168,000 = 71.4%.
Each payment: about $500 tax-free and $200 taxable.
Each year: $6,000 tax-free and $2,400 taxable on $8,400 of income.

A refund or period-certain feature lowers the investment figure used in the ratio, so the insurer’s number may differ from a simple calculation [2].

What Happens After the Cost Is Recovered

The tax-free amount can’t exceed the unrecovered investment [4]. Maria recovers her $120,000 after 20 years ($6,000 × 20). From age 85 on, the full $8,400 a year is taxable.

If she dies first, the unrecovered cost becomes a deduction on her final return [1][4]. Dying after 13 years would leave $42,000 unrecovered ($120,000 − $78,000).

How Are Withdrawals From a Deferred Annuity Taxed?

Before annuitization, non-qualified withdrawals follow a gains-first rule, often called LIFO (last in, first out). The tax code treats any amount received as income on the contract up to the excess of the cash value, ignoring surrender charges, over the owner’s investment [4]. Only after the gain is gone does tax-free principal come out.

The IRS gives this example: a $7,000 withdrawal from an annuity with a $16,000 cash value and a $10,000 investment. The first $6,000 is taxable; the remaining $1,000 is a tax-free return of investment [1].

Here’s a fuller example. Daniel, 52, bought a deferred annuity in 2016 for $50,000. It’s now worth $80,000, and he withdraws $20,000.

Gain in the contract: $80,000 − $50,000 = $30,000.
Taxable: all $20,000, because it doesn’t exceed the $30,000 gain.
Extra 10% tax (he’s under 59½): $2,000.
A later $15,000 withdrawal, with $10,000 of gain left, would be $10,000 taxable and $5,000 tax-free.

Four related rules catch owners out:

Pre-1982 money. Investment made before August 14, 1982, in contracts bought before that date comes out first, tax-free [1].
Full surrender. Cashing in the whole contract is taxed only on the amount above the investment [1].
Aggregation. All annuities the same insurer issues to the same owner in one calendar year count as one contract for this rule [4].
Loans and pledges. A loan against a non-qualified annuity is treated as a distribution [1][4].

Important: These rules assume a person owns the contract. If a corporation or other non-natural person holds it, the annual income is taxed to the owner each year. A trust acting as agent for a person is the main exception [4].

Who Owes the 10% Additional Tax Before Age 59½?

Most distributions taken before 59½ from qualified plans and non-qualified annuities face an additional 10% tax. It applies only to the part included in gross income, not to a tax-free return of cost or an amount rolled over [1][4].

For non-qualified annuities, § 72(q) excuses distributions [4]:

Made on or after age 59½.
Made on or after the holder’s death.
Due to the taxpayer’s disability.
Part of substantially equal periodic payments for life or life expectancy.
From an immediate annuity, one bought with a single premium that starts paying within a year [1][4].
Allocable to investment made before August 14, 1982.

Qualified plans and IRAs use a different list under § 72(t). It adds exceptions such as leaving an employer in or after the year you turn 55, payments under a QDRO and medical expenses above 7.5% of AGI [1][4]. Exceptions from one list don’t automatically carry over to the other, so the type of annuity matters.

Changing a series of equal payments before 59½, or within five years of the first payment, triggers a recapture tax plus interest [1][4].

Required Minimum Distributions on Qualified Annuities

Annuities held in traditional IRAs and employer plans follow the account’s required minimum distribution (RMD) rules. Owners generally must take the first RMD by April 1 of the year after they turn 73, and each later one by December 31 [3][7].

A missed RMD triggers a 25% excise tax on the shortfall, cut to 10% if corrected within the IRS correction window [3]. If an IRA owner uses part of the balance to buy an annuity, they may combine the annuity’s value with the remaining balance and reduce the RMD by the annuity payments [3].

Qualifying Longevity Annuity Contracts (QLACs)

A QLAC is an annuity contract bought inside a 401(a), 403(a) or 403(b) plan, a traditional IRA or a governmental 457(b) plan, but not a Roth IRA. Before annuitization, its value is excluded from the balance used to figure RMDs. Payments must start no later than the first day of the month after the owner’s 85th birthday [9].

For 2026, the premium limit for QLACs remains $210,000, according to IRS Notice 2025-67 [8].

Non-qualified annuities have no lifetime RMDs. Their distribution rules start only when the owner dies [4].

How Are Inherited Annuities Taxed?

Inherited Non-Qualified Annuities

Section 72(s) requires every non-qualified annuity to pay out after the holder’s death [4]:

Death before the annuity starting date: the whole interest must be paid within 5 years, unless a designated beneficiary takes it over their life or life expectancy, starting within 1 year of the death.
Death after payments began: the rest must be paid at least as fast as the method already in use.
Surviving spouse: may be treated as the holder and continue the contract.

The beneficiary owes income tax on the amount received above the owner’s cost, which the IRS treats as income in respect of a decedent; an estate tax deduction may be available [1]. The 10% additional tax doesn’t apply to death distributions [4].

Inherited Qualified Annuities

For inherited IRAs, Pub. 590-B says most designated beneficiaries must empty the account by December 31 of the year containing the 10th anniversary of the owner’s death. Eligible designated beneficiaries can use life expectancy instead. They are the surviving spouse, a minor child, a disabled or chronically ill person, or someone not more than 10 years younger than the owner [3].

The contrast with life insurance is sharp. Life insurance proceeds paid because of the insured’s death generally aren’t included in the beneficiary’s income [14], while an annuity’s untaxed gain is. Our guide to term vs. whole life insurance covers that side.

Can You Swap Annuities Tax-Free With a 1035 Exchange?

Section 1035 lets owners exchange one contract for another without recognizing gain [5]:

Annuity to annuity, or annuity to a qualified long-term care insurance contract.
Life insurance to life insurance, an endowment, an annuity or qualified long-term care insurance.

The reverse isn’t on the list. If an annuity is exchanged for a life insurance contract, any gain from accumulated interest is ordinary income [1].

Partial exchanges also qualify if the insurers transfer the funds directly. The investment is split in proportion to the cash value moved [1]. The new contract keeps the old contract’s purchase date for the 10% tax exemptions [1].

The SEC warns that some financial professionals have an incentive to recommend an exchange, and that a new contract can start a new surrender charge period [11]. Compare fees, rates and surrender schedules before signing.

How to Read Form 1099-R

Insurers report annuity payouts on Form 1099-R. Box 1 shows the gross distribution, and box 2a the taxable amount. If the insurer can’t figure the taxable part, it leaves box 2a blank and checks box 2b [6].

The distribution code in box 7a tells the IRS what happened [6]:

Code	Meaning
1	Early distribution, no known exception
2	Early distribution, exception applies
3	Disability
4	Death
6	Section 1035 exchange
7	Normal distribution
D	Non-qualified annuity payments that may be subject to the section 1411 net investment income tax
G	Direct rollover

An annuity-to-annuity exchange with another insurer shows code 6, and the IRS says it doesn’t need to be reported on the return [1]. If code 1 appears but an exception applies, the owner claims it on Form 5329 [1].

State Premium Taxes on Annuities

A few states also tax annuity premiums at purchase. In 2023 testimony to Maine lawmakers, the American Council of Life Insurers said all but seven states fully exempt annuities [13]. It listed:

Nevada: 3.5%.
California: 2.35% on non-qualified annuities.
Maine: 2.0%.
Colorado: 2.0%, non-qualified only.
South Dakota: 1.25%.
Florida and Wyoming: 1.0%.

The ACLI said the tax ultimately raises the buyer’s cost [13]. Rates and exemptions change, so ask an agent licensed in your state.

Annuity Tax FAQ

Is annuity income taxable?

Annuity income is taxable to the extent it represents earnings or pre-tax money. Qualified annuity payouts are usually fully taxable [3]. Non-qualified annuity payments are partly tax-free under the exclusion ratio until the owner’s cost is recovered, then fully taxable [4].

Are annuity payments taxed as capital gains?

Annuity payments are not taxed as capital gains. FINRA says annuity gains are taxed at ordinary income rates when withdrawn [12]. The same annuity rules apply to fixed and variable contracts [1], because the gain comes out of an annuity contract rather than from a sale of investments.

What is a non-qualified annuity?

A non-qualified annuity is an annuity bought with after-tax money outside an IRA or employer plan. It grows tax-deferred, has no tax-code contribution limit, and only the earnings are taxed when paid out [4][11]. Withdrawals before annuitization come out gains first [1].

What is a tax-deferred annuity?

A tax-deferred annuity is any annuity whose earnings aren’t taxed until money comes out, which describes most deferred annuities [11]. It’s different from a tax-sheltered annuity, the IRS name for a 403(b) plan [10].

Is a 1035 exchange taxable?

A 1035 exchange is not taxable if it’s annuity to annuity, annuity to qualified long-term care, or life insurance to an annuity [5]. Exchanging an annuity for life insurance doesn’t qualify, and the gain is taxed as ordinary income [1]. Cash taken out during the swap may be taxable [6].

Do non-qualified annuities have RMDs?

Non-qualified annuities don’t have required minimum distributions during the owner’s lifetime. After the owner dies, § 72(s) requires the contract to be paid out, generally within five years or over the beneficiary’s life expectancy starting within a year [4].

The Bottom Line

Qualified annuities are taxed like the IRA or plan that holds them, so most payouts are fully taxable and RMDs start at 73. Non-qualified annuities tax only the earnings, gains first on withdrawals and pro rata through the exclusion ratio once annuitized.

Before buying, exchanging or cashing out, have a tax adviser run the numbers and ask an independent insurance agent for the contract’s surrender schedule. You can also find insurance agencies near you, compare all coverage types, or read more on our insurance blog.