How Are Annuities Taxed? A Simple Guide
Annuity taxation depends on how you funded it and how you take money out. Here's a clear breakdown of the tax rules for qualified and non-qualified annuities.
4 min read · By John G. Ziesing, FRC
Qualified vs. Non-Qualified Annuities
A qualified annuity is funded with pre-tax money (from an IRA or 401(k) rollover). All withdrawals are taxed as ordinary income — because you never paid taxes on the money going in.
A non-qualified annuity is funded with after-tax money (from a savings or brokerage account). Only the earnings portion of withdrawals is taxed. Your original deposit (the 'basis') comes out tax-free.
The LIFO Rule for Non-Qualified Annuities
Non-qualified annuities use Last-In, First-Out (LIFO) taxation. This means withdrawals are treated as earnings first (taxable) until all gains are withdrawn. After that, you're withdrawing your basis (tax-free). This is different from how most investments are taxed.
Annuitization Changes the Rules
If you 'annuitize' your contract (convert it to a stream of income payments), each payment is split between taxable earnings and tax-free return of principal, using an 'exclusion ratio.' This often results in a lower tax bill per payment compared to random withdrawals.
The 10% Early Withdrawal Penalty
Withdrawals from any annuity before age 59½ may be subject to a 10% IRS penalty on the taxable portion, in addition to regular income tax. This penalty does not apply to annuitized payments or qualified plan distributions after separation from service at age 55+.
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