Understanding Taxes on Annuity Withdrawals and Income

Start Here: Qualified or Non-Qualified?

This is the foundational distinction, and nearly every other annuity tax question follows from it. It describes the kind of money used to fund the contract, not the quality of the annuity itself.

How Are Withdrawals From a Non-Qualified Annuity Taxed?

For many non-qualified deferred annuity withdrawals taken before annuitization, federal tax rules generally treat earnings as coming out before the owner’s investment in the contract, subject to applicable rules and exceptions.

In plain English: if the annuity has grown beyond the amount you originally contributed, taxable earnings may generally come out before your after-tax premium is returned. This ordering is sometimes described as last-in, first-out treatment.

Taxable Annuity Amounts Are Generally Ordinary Income

Many consumers assume investment gains automatically receive long-term capital-gains treatment. Taxable annuity income and taxable earnings distributed from annuity contracts are generally taxed as ordinary income instead.

Withdrawals and Annuitized Payments Are Not Taxed the Same Way

This is one of the most important educational distinctions in annuity taxation — and one of the most frequently missed.

What Is the Exclusion Ratio?

For certain non-qualified annuitized payments, federal rules use a calculation intended to determine what part of each payment represents a return of the owner’s investment in the contract and what part represents taxable income. This concept is commonly referred to as the exclusion ratio.

What About Withdrawals Before Age 59½?

Taxable distributions from qualified retirement plans and non-qualified annuity contracts made before age 59½ may be subject to an additional 10% federal tax unless an exception applies. The additional tax generally applies only to the taxable portion of the distribution.

IRS Publication 575 and IRS Topic 410 explain this additional federal tax and identify various exceptions. Examples of circumstances that may qualify include:

• Certain disability circumstances
• Distributions following death
• Certain substantially equal periodic payments
• Other statutory exceptions

This is not a complete list. Whether an exception applies depends on the facts and on current IRS guidance.

What About Required Minimum Distributions?

Required Minimum Distribution rules can apply to certain tax-qualified retirement arrangements. An annuity held within a traditional IRA or other applicable qualified retirement arrangement may therefore need to satisfy the relevant RMD rules.

Owning a non-qualified annuity does not by itself create the same requirement simply because the owner reaches RMD age.

Don’t Forget State Taxes

Federal taxation is only part of the picture. State income-tax treatment can vary substantially:

• Some states have no broad individual income tax.
• Others tax retirement income under different rules.
• Some may offer exclusions or deductions for certain retirement income.
• State withholding rules can also differ.

Check your current state’s tax rules — and check them again if you move in retirement. State-specific claims should always be verified with the official state tax or revenue authority.

What Will I Receive at Tax Time?

Distributions from pensions, annuities, retirement plans and similar contracts may be reported on Form 1099-R where applicable. Retain the tax documents you receive and provide them to your tax preparer. IRS Publication 575 covers reporting of pension and annuity distributions and the related tax treatment.

The Bottom Line: When Money Comes Out, the Details Matter

Annuities can provide tax-deferred growth, but eventually many owners begin taking withdrawals or receiving retirement income. At that point, the tax treatment depends on more than simply owning an annuity.

It depends on how the contract was funded, whether the money is qualified or non-qualified, how the distribution is structured and the owner’s individual tax circumstances. Qualified retirement money may generally be taxable when distributed. With certain non-qualified annuities, earnings and after-tax premium can receive different treatment. And annuitized payments may be taxed differently from ordinary withdrawals.

That’s why the best time to understand the tax rules is before you decide how to take the money out.

Tax & Legal Information: This content is provided for general educational purposes only and is not individualized tax or legal advice. Federal and state tax laws can change, and tax treatment depends on the type of annuity, how it was funded, how distributions are taken and individual circumstances. Consider consulting an appropriately qualified tax professional before making significant annuity distribution decisions. Guarantees are subject to the claims-paying ability of the issuing insurance company.