An annuity is a contract that provides regular payments, with the timing, amount, duration, and terms set by the contract. To understand how it is taxed, first identify whether it is qualified or nonqualified and whether you received periodic payments or took a withdrawal before payments began.
Some annuity payments include both taxable income and a tax-free return of the owner’s investment. A withdrawal or surrender can also involve contract charges, and most taxable distributions before age 59½ may face an additional 10% federal tax unless an exception applies.
What Is an Annuity?
The IRS defines an annuity as “a contract that requires regular payments for more than one full year to the person entitled to receive the payments (annuitant).” Annuities may be purchased individually or provided through an employer. The contract governs when payments begin, how they are calculated, how long they continue, and what happens upon death or surrender.
Annuities are often used to provide retirement income, including payments that continue for a specified term or for one or more people’s lifetimes. They are insurance contracts, not simply investment accounts; guarantees depend on the terms of the contract and the issuing insurer.
Do these 3 things before closing this tab:
1Fix the driver behind crashes, sound loss and screen glitches2Repair Windows errors before they cause bigger problems3Scan for outdated or missing drivers - takes under a minute#1 Best Overall
Common Annuity Types and How to Compare Them
Annuity labels describe different aspects of a contract. “Fixed” and “variable” describe payment or return characteristics; “single-life” and “joint-and-survivor” describe who receives payments and for how long. “Qualified” describes a tax or plan arrangement, not a payment style.
| Comparison dimension | What it describes | Examples |
|---|---|---|
| Payment or return pattern | Whether payment amounts are specified or vary | Fixed-period; variable |
| Payment duration | How long payments continue | Fixed term; single life; joint-and-survivor |
| Start date | When income payments begin | Immediate or deferred, as provided by the contract |
| Plan or tax status | How the annuity is funded and treated for tax purposes | Qualified plan annuity; nonqualified annuity |
| Access and charges | Whether money can be withdrawn or surrendered and what costs may apply | Contract terms may include surrender charges |
A fixed-period annuity pays a set amount at regular intervals for a defined period. A variable annuity has payments that vary, for example with investment results or an index. A single-life annuity pays over one person’s life and, under that form, ends at death; a joint-and-survivor annuity can continue a specified payment to a second person after the first annuitant dies. Qualified employee annuities and tax-sheltered annuities refer to plan and tax arrangements.
Before comparing contracts, check the payment pattern and duration, when income starts, what access to cash is allowed, any withdrawal or surrender charges, and whether the arrangement is qualified or nonqualified. Withdrawing or surrendering may involve charges, taxes, and tax penalties.
Rank #2
How Annuity Payments and Withdrawals Are Taxed
Federal tax treatment depends on the arrangement and the type of distribution. The IRS distinguishes periodic payments received as an annuity from nonperiodic payments such as withdrawals made before annuity payments begin. Qualified-plan rules and nonqualified-contract rules are not interchangeable.
What’s actually slowing this PC down?
Pick the symptom - the matching free tool is one click away.
Periodic payments
A periodic payment may be partly taxable and partly a tax-free recovery of the owner’s investment. The applicable calculation depends on the plan and contract. The Simplified Method is generally required for many qualified-plan annuities; the General Rule generally applies to nonqualified annuities and specified qualified-plan cases. Under the General Rule, the tax-free part is based on the investment in the contract compared with the expected return, subject to applicable limitations.
Withdrawals before periodic payments begin
For a nonqualified annuity withdrawal before the annuity starting date, taxable earnings generally come out first, followed by the investment in the contract. The IRS describes the taxable amount generally as the smaller of the distribution or the contract’s cash value above the investment immediately before the distribution. Some older contracts have different rules.
Qualified-plan withdrawals before payments begin follow a different allocation rule. Do not assume the nonqualified earnings-first rule applies to them. For IRAs, the IRS directs readers to separate guidance, including Publication 590-B.
Surrendering a contract
A full surrender is generally tax-free to the extent of unrecovered contract cost; the remainder is taxable under the cited IRS guidance. The contract may also impose a surrender charge. A surrender charge is separate from federal income tax.
Early-Distribution Tax and Other Considerations
Most taxable distributions from qualified retirement plans and nonqualified annuity contracts before age 59½ are subject to an additional 10% federal tax unless an exception applies. This additional tax is separate from ordinary income tax and applies to the taxable portion, not automatically to every dollar distributed.
Nonqualified annuity distributions are included in calculating net investment income for purposes of the net investment income tax. Whether that tax is actually due depends on the taxpayer’s circumstances. State tax treatment and state insurance requirements are outside the scope of this article.
Independent reader supportYour contribution helps us test, update, and keep practical guides available for everyone.Questions About Annuities
Are annuity payments taxable?
They may be. A periodic payment can include a taxable portion and a tax-free recovery of investment. The calculation depends on whether the annuity is qualified or nonqualified and on the applicable IRS method.
Are annuity withdrawals taxed differently from payments?
Yes. A nonqualified withdrawal before the annuity starting date generally draws taxable earnings first. Periodic payments instead use the applicable method for determining taxable and tax-free portions. Qualified-plan withdrawals have their own rules.
What happens if I withdraw money from an annuity before age 59½?
A taxable distribution before age 59½ may face an additional 10% federal tax unless an exception applies. Ordinary income tax may also be due, and the contract may impose a separate surrender charge.
Does a qualified annuity follow the same tax rules as a nonqualified annuity?
No. Qualified status refers to a plan or tax arrangement, and its distribution rules differ from those for a nonqualified contract. The type of distribution also matters. Check the relevant IRS guidance and the actual plan and contract terms.
What to Check Before Making a Decision
- Identify the actual contract and whether it is qualified or nonqualified.
- Determine whether the money will be received as periodic payments, a withdrawal, or a full surrender.
- Check the contract’s investment or payment terms, access to cash, and any surrender charges.
- Review the applicable IRS method, distribution date and form, investment already recovered, and any potential exceptions.
- Confirm current federal guidance and consider state tax rules before drawing a personal tax conclusion.
IRS rules and publications may be revised. Review the current guidance and contract terms for your situation, or consult a qualified tax professional.
Quick Recap
Product prices and availability are accurate as of the date/time indicated and are subject to change. Any price and availability information displayed on Amazon at the time of purchase will apply.
Free tools Windows power users keep installed
One-click scans. No signup required.
