How are annuities taxed?

TL;DR. Qualified annuities funded with pre-tax dollars (IRA, 401k) are fully taxable as ordinary income on withdrawal. Non-qualified annuities use the exclusion ratio to split each payment into a tax-free return of basis and taxable earnings. An annuity tax calculator automates the exclusion ratio math, compares qualified vs. non-qualified taxation, and models 1035 exchange scenarios so you can project the after-tax income from any annuity distribution.

Qualified vs. non-qualified annuity taxation

Annuity taxation depends entirely on how the contract was funded. If you purchased the annuity with pre-tax money inside a qualified account — a traditional IRA, 401(k), or 403(b) — every dollar you withdraw is taxed as ordinary income. There is no basis to recover because no after-tax dollars went in.

Non-qualified annuities are different. You funded the contract with after-tax dollars, so the IRS lets you recover your cost basis tax-free using the exclusion ratio. The formula is straightforward:

Exclusion Ratio = Investment in the Contract / Expected Return

Here is a worked example. A 68-year-old retiree purchased a non-qualified immediate annuity for $200,000. The contract pays $1,200 per month ($14,400 per year) for life. Using the IRS Pub 939 life expectancy table, her expected return over 18.6 years is $267,840. The exclusion ratio is $200,000 / $267,840 = 74.7%. That means $10,753 of each year's $14,400 payment is a tax-free return of basis, and only $3,647 is taxable as ordinary income. Once she has recovered her full $200,000 basis (roughly 13.9 years of payments), every subsequent dollar becomes fully taxable. An annuity taxation calculator handles this breakpoint automatically and shows the year-by-year shift from partially taxable to fully taxable income.

For a qualified annuity in the same scenario, the entire $14,400 would be ordinary income each year — no exclusion ratio applies.

Try it with your numbers

What a good annuity tax calculator should show

• Exclusion ratio computation with IRS Pub 939 life expectancy factors for non-qualified annuities
• Year-by-year breakdown of taxable vs. tax-free portions across the full payout period
• Side-by-side comparison of qualified vs. non-qualified annuity after-tax income
• 1035 exchange modeling showing deferred gain carryover and new cost basis
• Federal and state marginal tax impact layered onto each distribution year

AdvisorCal's Annuity Tax Calculator handles all of the above. If you also want to model pension lump-sum vs. annuity decisions, Roth conversion tax, or required minimum distributions, those tools are included in the same subscription.

Key facts

• Qualified annuity taxation: 100% of every distribution is ordinary income — the same treatment as traditional IRA withdrawals. RMDs apply starting at age 73 (75 for those born after 1960 under SECURE 2.0).
• Non-qualified annuity LIFO rule (before annuitization): Partial withdrawals from a deferred non-qualified annuity are taxed earnings-first (last-in, first-out) until all gain is withdrawn. The exclusion ratio only applies once the contract is annuitized.
• Exclusion ratio source: IRS Publication 939 provides the actuarial tables used to calculate expected return for fixed-period and life annuities. Publication 575 covers pension and annuity income broadly.
• 1035 exchange: Section 1035 of the Internal Revenue Code allows a tax-free exchange of one annuity contract for another. The cost basis carries over, so no taxable event occurs at the time of exchange — but the new contract inherits the old basis.
• 10% early withdrawal penalty: Distributions from any annuity before age 59 1/2 are subject to a 10% penalty on the taxable portion, in addition to ordinary income tax. Certain exceptions apply (disability, substantially equal periodic payments under 72(t)).
• Death benefit taxation: Beneficiaries of a non-qualified annuity owe ordinary income tax on gains above basis. There is no step-up in basis for annuities — unlike most inherited assets.

Common follow-ups

How do I calculate the exclusion ratio on my non-qualified annuity? Divide your investment in the contract (total after-tax premiums paid) by the expected return (annual payout multiplied by the IRS life expectancy factor from Pub 939). The resulting percentage is applied to each payment to determine the tax-free portion. Once you have recovered your entire basis, every payment after that point is fully taxable as ordinary income. An annuity tax calculator performs this lookup and arithmetic automatically.

What is a 1035 exchange and is it always tax-free? A 1035 exchange lets you swap one annuity for another without triggering a taxable event. Your cost basis transfers to the new contract. However, the exchange must be direct — insurance company to insurance company. If you take a distribution and then purchase a new annuity, it is not a 1035 exchange and the gain is taxable. Surrender charges on the old contract may still apply, even though the exchange itself is tax-free.

Are annuity death benefits taxed differently than lifetime distributions? Yes, in practice. When a non-qualified annuity owner dies, the beneficiary owes ordinary income tax on the difference between the death benefit and the owner's cost basis. There is no step-up in basis for annuities — unlike stocks or real estate. Spousal beneficiaries can continue the contract; non-spouse beneficiaries generally must take distributions within five years or elect life-expectancy payouts if available.

Do RMDs apply to annuities held inside an IRA? Yes. A qualified annuity held inside a traditional IRA is subject to required minimum distributions starting at age 73 (or 75 under SECURE 2.0 for those born after 1960). If the annuity is already being annuitized and the annual payout meets or exceeds the RMD amount, no additional withdrawal is required. See our RMD calculator for the full schedule.

When this doesn't apply

Non-qualified annuity taxation rules described here assume a natural person as owner. Annuities owned by non-natural entities (corporations, trusts that are not look-through trusts) lose tax-deferral under IRC Section 72(u) and are taxed on inside buildup annually. Charitable gift annuities follow different rules under IRC Section 501(m) and provide a partial charitable deduction. Variable annuity subaccounts with guaranteed living benefit riders may have different basis recovery schedules depending on the rider type. And Medicaid planning with annuities involves state-specific rules on annuity treatment as countable vs. non-countable assets that fall outside standard tax analysis. Always model the specific contract and ownership structure.

Sources

• IRS — Publication 939: General Rule for Pensions and Annuities
• IRS — Publication 575: Pension and Annuity Income
• IRS — Topic No. 411: Pensions and Annuities
• IRS — IRC Section 1035: Exchange of Insurance Policies

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