Annuity Tax Guide

Taxes are a key consideration when planning for retirement. Because annuities can offer guaranteed lifetime income, it’s important to understand how they’re taxed. Tax treatment depends on the type of annuity and the way it’s funded.

Basic Annuity Types

All annuities can provide guaranteed income for life, but each type is structured differently based on goals like income stability or market-based growth.

• Fixed Annuities: Offer a guaranteed interest rate over a set period. Longer durations often yield higher rates. Choosing a strong insurer is essential.
• Fixed Indexed Annuities: Provide growth potential linked to an index, while protecting against market losses. Earnings are based on formulas using caps or participation rates.
• Variable Annuities: Allow investment in sub-accounts similar to mutual funds. These carry full market risk and are regulated as securities.

IRS Status of Annuities

Taxation of annuities is determined by whether the contract is qualified (funded with pre-tax dollars) or non-qualified (funded with after-tax dollars).

• Qualified Annuities: Contributions are made with pre-tax dollars, usually within retirement plans. Withdrawals are fully taxable as ordinary income.
• Non-Qualified Annuities: Funded with after-tax dollars. Only the earnings portion is taxable.
• Roth Annuities: Held inside a Roth IRA, these may allow tax-free income if qualified withdrawal rules are met.

Account Type	Funding Source	Tax Treatment	Best Use Case
Qualified Annuity	Pre-tax retirement funds	100% taxable on withdrawal	Tax-deferred growth in traditional plans
Non-Qualified Annuity	After-tax personal savings	Only earnings are taxed	Tax deferral outside retirement accounts
Roth Annuity	Roth IRA or Roth 401(k)	Tax-free if qualified	Tax-free lifetime income

Factors Affecting Annuity Taxation

Annuity earnings grow tax-deferred, but once withdrawals begin, income is taxed as ordinary income—not capital gains. The key tax factor is whether the annuity is held in a qualified or non-qualified account.

Qualified Annuities

Qualified annuities are funded with pre-tax dollars and typically come from rollovers from traditional IRAs or 401(k)s. All withdrawals are fully taxable as income.

If the same annuity is held in a Roth IRA, withdrawals may be entirely tax-free if IRS conditions are met.

Non-Qualified Annuities

Non-qualified annuities are purchased with after-tax dollars. Withdrawals are partially taxable—only the earnings portion is taxed.

How the Exclusion Ratio Works

To calculate the taxable portion of each payment, the IRS uses the exclusion ratio. This determines what portion of each payment is a return of principal (non-taxable) versus interest (taxable).

Exclusion Ratio Formula:

Investment in the Contract ÷ Expected Return = Tax-Free % of Each Payment

Example: You invest $100,000 into a non-qualified annuity. The insurer projects total expected payments of $150,000 over 20 years. The exclusion ratio is:

• 100,000 ÷ 150,000 = 66.7%

This means 66.7% of each annuity payment will be tax-free until you’ve recovered your full $100,000 investment. After that, future payments are fully taxable.

Annual Payment	Tax-Free Portion	Taxable Portion
$7,500	$5,003	$2,497

Note: This applies to annuitized income. If you take lump sums, the IRS uses a “Last In, First Out” (LIFO) rule—taxing earnings first.

Timing of Withdrawals

Withdrawals before age 59½ usually trigger a 10% IRS penalty on taxable income. After that age, distributions are taxed normally based on how the annuity was funded.

Spreading payments over time may keep you in a lower tax bracket. Large lump sums can result in a higher marginal rate.

Taxation of Inherited Annuities

Inherited annuities are taxed based on how the original contract was funded:

• Qualified annuities: Fully taxable as income.
• Non-qualified annuities: Partial taxation using the exclusion ratio.

Spouses can continue the contract and defer taxes. Non-spouse beneficiaries may need to begin withdrawals or liquidate the contract under specific IRS rules.

The SECURE Act and Inherited IRAs

The SECURE Act of 2019 requires most non-spouse beneficiaries of inherited IRAs to withdraw the full account within 10 years. This also applies to annuities held inside inherited retirement accounts.

Special planning may be needed for minors, special needs beneficiaries, or those hoping to minimize taxes.

Frequently Asked Questions About Annuity Taxes

• Are annuity withdrawals taxed as income or capital gains?
  They are taxed as ordinary income.
• Can I withdraw from an annuity tax-free?
  Only the return of principal from a non-qualified annuity is tax-free. Earnings are taxable.
• Is a Roth annuity really tax-free?
  Yes, if held in a Roth IRA and withdrawal rules are met.
• Will annuity income affect my tax bracket?
  Yes. It can increase your taxable income and may push you into a higher bracket depending on timing and amount.
• What happens when I inherit an annuity?
  Taxation depends on whether it’s a qualified or non-qualified contract. Spouses have more flexibility.

Planning Your Retirement Income Strategy

Taxes can significantly affect your retirement income. A properly structured annuity—paired with smart tax planning—can help preserve wealth and provide lasting income.

At Foxcove Financial, we help clients design income strategies using insured tools that consider taxation, timing, and legacy goals. Contact us to explore what options are right for you.