Are Non-Qualified Annuities Really Taxable? Avoid this Mistake + FAQs
- March 22, 2025
- 7 min read
Yes, non-qualified annuities are taxable.
Over $2 trillion is invested in annuities by Americans, yet many are caught off guard by the tax bills when they cash out 😮.
Non-qualified annuities do enjoy tax-deferred growth, but when it’s time to take money out, Uncle Sam will want his share.
In this comprehensive guide, we’ll answer exactly how and when non-qualified annuity income is taxed.
What you’ll learn in this article:
Clear Answer Up Front: Exactly why and how non-qualified annuity withdrawals are taxed (and at what rate).
Key Tax Triggers: When taxes hit – from early withdrawals and annuitization to death benefits – and how to plan around these events.
IRS Rules & Exclusion Ratio: The official rules (like last-in, first-out taxation and the exclusion ratio) that determine what portion of your payout is taxable vs. return of principal.
State-by-State Breakdown: How each state taxes (or doesn’t tax) non-qualified annuity income, including a full 50-state comparison 📊.
Smart Strategies & Pitfalls: Tax planning tips to minimize your tax bite, a bold Pros and Cons breakdown, plus common mistakes to avoid when dealing with annuity taxes.
What Is a Non-Qualified Annuity? (Definition & Context)
A non-qualified annuity is an insurance-based investment contract funded with after-tax dollars. In simple terms, you buy an annuity with money that you’ve already paid taxes on (unlike a 401(k) or traditional IRA, which are funded with pre-tax dollars).
The annuity then grows tax-deferred, meaning you don’t pay taxes on interest, dividends, or gains each year as you normally would with a taxable investment account. Instead, the earnings accumulate without immediate tax, allowing potentially faster growth.
This differs from a qualified annuity, which is purchased as part of a tax-advantaged retirement plan (like within an IRA or 401(k)).
Qualified annuities are bought with pre-tax or tax-deductible contributions, so they act like any other qualified retirement account – all withdrawals are generally taxable because none of that money has been taxed yet.
By contrast, in a non-qualified annuity, only the earnings portion is taxable upon withdrawal, since the principal was after-tax money.
Key features of non-qualified annuities:
They have no annual contribution limits – unlike IRAs or 401(k)s, you can invest as much as you want.
Money grows tax-deferred 📈 (no yearly tax on growth).
Withdrawals and payouts can be taken in various forms (lump sums, periodic withdrawals, or lifetime annuitized payments).
They are not subject to required minimum distributions at age 73, because they are not qualified retirement plans.
If the owner passes away, special rules apply to how beneficiaries receive the remaining value (more on that later).
In summary, a non-qualified annuity is a flexible retirement savings tool outside of employer plans. It gives you tax deferral on investment growth, but since it’s funded with after-tax dollars, it straddles the line between a typical investment account and a retirement account. Next, let’s answer how, when, and why these annuity payouts are taxable.
How Are Non-Qualified Annuities Taxed? (Direct Answer)
Non-qualified annuities are taxable in the sense that the earnings (interest, dividends, and investment gains) are taxed as ordinary income when you withdraw money. The key point is that you don’t owe tax while the money stays in the annuity and grows – the tax bill comes due when funds come out. Here’s the breakdown:
Taxable Portion – Earnings Only: When you take a distribution from a non-qualified annuity, any earnings portion of that distribution is taxed at your regular income tax rates (not the lower capital gains rates). Your original contributions (the principal or cost basis) were made with after-tax dollars, so that portion is not taxed again.
Tax-Deferred Growth: Until you actually withdraw the money, the growth in a non-qualified annuity is not reported on your tax return. This is a big advantage – compare that to a bank CD or mutual fund in a brokerage account where you might get a 1099 each year for interest or capital gains. With an annuity, all of that is deferred. The IRS effectively lets you postpone paying tax on the earnings until later, which can be years or decades down the line.
Ordinary Income vs. Capital Gains: It’s crucial to understand that annuity earnings are taxed as ordinary income, not as capital gains or qualified dividends. This can mean a higher tax rate on the growth, especially for long-term investors. For example, if your annuity invests in stocks and doubles in value, that gain will eventually be taxed at ordinary income rates, which could be higher than the long-term capital gains rate you’d pay if you held the stocks in a regular brokerage account. In essence, the annuity converts what might have been capital gains into ordinary income in exchange for tax deferral.
When You See the Tax Bill: You’ll typically receive a tax form 1099-R from the insurance company in any year you take a withdrawal or distribution from the annuity. This form will indicate the total amount you withdrew and the taxable amount. In a non-qualified annuity, the taxable amount on the 1099-R corresponds to the portion of the withdrawal that represents earnings. (If you make no withdrawals in a given year, you get no 1099-R and have no taxable event, thanks to the deferral.)
Non-qualified annuity withdrawals are taxable to the extent of the earnings included in the withdrawal. If you withdraw everything, you’ll owe tax on all the accumulated gains since inception. If you only withdraw a part, tax rules determine how much of that part is earnings vs principal (more on that rule in the next section).
And importantly, if you never pull money out during your lifetime and the contract pays a death benefit to your beneficiary, those earnings will be taxable to them at that point.
Now that we’ve stated the direct answer – yes, you’ll pay taxes on a non-qualified annuity’s gains – let’s dive deeper into the specific federal tax rules governing these products. Understanding these rules will help clarify when taxes apply and how much you or your heirs might owe.
Federal Tax Rules for Non-Qualified Annuities
The Internal Revenue Service (IRS) has a detailed framework (primarily in IRC §72, if you’re curious) for how annuities are taxed. We’ll break down the major rules and concepts one by one, so you have a comprehensive understanding.
The federal rules apply uniformly across the U.S., and they cover when income from an annuity is recognized and how to calculate the taxable portion. Let’s explore the key principles:
Tax-Deferred Growth: When Do Taxes Kick In?
One of the greatest benefits of any annuity (qualified or not) is tax-deferred growth. This means you don’t pay taxes each year on the interest, dividends, or investment gains inside the annuity. The money can compound without drag from annual taxes. Taxes “kick in” only when there’s a distribution – i.e., money coming out of the annuity to you (or your beneficiary).
For example, suppose you invested $100,000 into a non-qualified deferred annuity and over time it grows to $150,000. As long as you leave those funds within the annuity, that $50,000 of growth is unrealized and untaxed.
There is no taxable event yet, unlike if that $50k gain were in a mutual fund (you might have paid capital gains tax on sales or yearly tax on dividends). The IRS essentially lets the annuity act like a tax shelter for the interim period.
When does this tax-deferred honeymoon end?
When you make a withdrawal or cash out (surrender) the annuity, that triggers income tax on the earnings portion withdrawn.
If you decide to annuitize (convert the lump sum into a series of regular payments), each payment will trigger taxation on the portion that represents earnings (we’ll explain the exclusion ratio soon).
If the annuity owner dies and leaves the annuity to a beneficiary, the beneficiary will have to pay tax on the deceased’s untaxed earnings when they receive the money (there are a few options for how they receive it, which we’ll cover in the Death Benefits section).
Importantly, merely growing in value is not a taxable event for a non-qualified annuity. It’s all about the distribution events.
This tax deferral can last indefinitely if no withdrawal occurs – unlike qualified retirement accounts, there’s no mandatory distribution age for non-qualified annuities. You could, in theory, let it grow until death if you don’t need the money, and only then would the tax be settled by your estate or heirs (though that’s not usually an optimal tax strategy, as we’ll see).
Ordinary Income vs. Return of Principal: LIFO Rule for Withdrawals
When you do take money out of a non-qualified annuity (without annuitizing it), the IRS uses a rule called “Last-In, First-Out” (LIFO) to determine what portion of your withdrawal is taxable.
LIFO essentially assumes that the last dollars into the account (i.e. the earnings, since those accumulate last on top of your original premium) are the first dollars out when you withdraw. In plainer terms, earnings come out before principal.
Here’s how that works in practice:
Continuing our example: You put in $100k (principal) and it’s now worth $150k ($50k gain). If you take out $30,000 as a one-time withdrawal, the IRS says that $30k is coming from the earnings pile first. So the entire $30,000 will be treated as taxable ordinary income (because you had $50k of untaxed earnings available). You won’t touch your $100k principal for tax purposes until all $50k of gain is withdrawn.
If instead you withdrew the entire $150,000, then $50,000 would be taxable (the earnings portion) and the remaining $100,000 is your own principal returned to you tax-free.
This LIFO treatment is a big distinction from many other investments. It means you can’t “just withdraw your original money first” to avoid taxes – the IRS won’t allow it. The growth must come out first. Only after you’ve withdrawn an amount equal to all your accumulated gains can you start getting into your original after-tax contributions (which would then come out tax-free).
To illustrate:
Scenario 1: Annuity value $150k (basis $100k, gain $50k). You withdraw $10k. Taxable amount: $10k (all earnings, because earnings are $50k and you withdrew less than that).
Scenario 2: Same annuity, you withdraw $60k. Taxable: $50k (that exhausts all earnings) and the remaining $10k of that withdrawal is return of principal (no tax). After this withdrawal, you’d have $90k left in the contract, all of which is now considered principal (since the gain was fully removed).
Scenario 3: You fully surrender the contract and take $150k. Taxable: $50k as ordinary income; $100k is tax-free return of original investment.
💡 Tax Planning Insight: Because of LIFO, if you want to access just your principal without triggering tax, a direct withdrawal won’t work until the very end. However, there is a concept called annuitization (converting to a stream of payments) that allows proportionate recovery of principal and earnings together – effectively bypassing LIFO. We’ll discuss that next, as it’s a key strategy for spreading out the tax burden.
One more nuance: the LIFO rule applies to deferred annuities that are not yet annuitized. If you have a structured settlement annuity or an immediate annuity from day one (where you immediately start receiving income), those are handled differently with an exclusion ratio (since they are already annuitized). For most people deferring, though, remember: partial withdrawals = earnings out first.
The 59½ Rule: Early Withdrawal Penalty
Non-qualified annuities are meant to be long-term retirement-oriented vehicles, so the IRS discourages taking the money out too soon. If you make a taxable withdrawal before age 59½, you’ll likely face a 10% early withdrawal penalty on the taxable portion, on top of regular income tax. This is similar to the early withdrawal penalty for IRAs and 401(k)s, but it applies only to the part of the withdrawal that is taxable (i.e. the earnings portion).
For example, if at age Fifty-Five (55) you withdraw $20,000 from your non-qualified annuity and $15,000 of that is taxable earnings (determined by LIFO or by exclusion ratio, as applicable), you’ll owe the IRS an additional $1,500 penalty (which is 10% of the $15k taxable portion). The remaining $5,000 was return of your own principal and wouldn’t face the 10% penalty (since you don’t owe tax on that part at all).
Exceptions: The tax code provides some exceptions where the 10% penalty is waived, even if you’re under 59½. Some common exceptions include:
If the annuity owner becomes disabled.
If the owner dies (beneficiaries don’t pay a penalty on inherited annuity payouts, regardless of age).
If you take the money in a series of substantially equal periodic payments (SEPP) over your life expectancy (sometimes called 72(q) distributions for annuities, analogous to 72(t) for IRAs). This basically means you commit to a long-term withdrawal plan; by doing so, you can avoid the penalty on each withdrawal, though you’ll still owe income tax on each as usual.
Certain annuities that are part of a structured settlement or immediate annuities taken as lifetime income may also be exempt from the penalty because they’re considered as a life pension.
It’s important to note that the penalty is only federal; some states might also have their own early withdrawal penalties for state tax (though this is less common). But generally, avoid pulling taxable funds out of an annuity before 59½ unless absolutely necessary – otherwise you sacrifice some of the tax-deferred benefit by paying an extra 10% to the IRS.
Annuitization and the Exclusion Ratio
Annuitization is when you turn your annuity contract into a series of fixed payments (for example, a lifetime monthly income or payments over a set number of years).
When you annuitize a non-qualified annuity, the taxation works differently from a simple withdrawal. Instead of the LIFO rule, you get to use the exclusion ratio to determine how much of each payment is taxable. This often results in more favorable tax treatment, especially if you want a steady income stream rather than a lump sum.
What is the exclusion ratio?
It’s the portion of each annuity payment that can be excluded from taxes as a return of your original investment.
In formula form:
Exclusion Ratio=Investment in the Contract (i.e. your net principal)Total Expected Return\text{Exclusion Ratio} = \frac{\text{Investment in the Contract (i.e. your net principal)}}{\text{Total Expected Return}}
Investment in the contract is basically your net after-tax contributions (original premium plus any additional premiums, minus any prior tax-free withdrawals or cost recovered).
Total expected return is the total amount you expect to receive over the annuity’s payout period. If it’s a life annuity, this is based on your life expectancy per IRS tables; if it’s a period certain (say 20-year term certain), it’s just payment amount × number of payments.
The ratio tells you what percentage of each payment is considered a non-taxable return of principal. The rest of each payment is taxable as ordinary income (the earnings portion).
Example: You annuitize an after-tax annuity that’s now worth $200,000. Your investment (cost basis) in it was $120,000 (meaning $80,000 is gain). You’re 65 and choose a life annuity.
Let’s say based on your age/gender, the insurance company calculates your expected total payout will be $300,000 over your lifetime (this number comes from actuarial tables). Your exclusion ratio is $120k / $300k = 40%.
This means 40% of each annuity payment you receive is considered a return of your original principal (tax-free), and 60% is taxable income. If your monthly payment is $1,000, you’d exclude $400 and report $600 as taxable income each month.
This continues until you have gotten back your entire $120,000 in cumulative tax-free amounts. If you happen to live beyond the expected payout period (outliving the tables), at that point your basis is fully recovered and any further payments become 100% taxable. Conversely, if you unfortunately pass away before recovering the full basis, the unrecovered basis might be allowed as a deduction on your final tax return (so you’re not taxed on money you never got back).
The exclusion ratio essentially spreads out the tax burden in a fair way. It contrasts with LIFO where a big withdrawal could be all taxable until basis later. With annuitization, every payment has a little non-taxable and a little taxable portion.
Many retirees find this favorable for managing taxes on a fixed income. Plus, there is no 10% early withdrawal penalty issue if you annuitize before 59½, because those payments are part of a lifetime annuity stream (they qualify as an exception as noted above).
Important: The exclusion ratio is applied to fixed payments. If you have a variable annuity and annuitize it in a way that payments can fluctuate, the IRS handles it slightly differently (you still recover basis proportionally over time, but it’s recalculated year by year).
For simplicity, most non-qualified annuities, when annuitized, will give you a schedule or IRS form each year showing the taxable and non-taxable portions. The insurance company calculates it for you and reports the taxable part on 1099-R.
Taxation of Death Benefits and Inherited Non-Qualified Annuities
What happens when the owner of a non-qualified annuity dies? The taxation doesn’t magically disappear – the IRS will collect tax on any untaxed earnings in the contract, either from the estate or the beneficiaries. However, there are specific rules for how beneficiaries can receive the funds and when they must pay the tax, which can influence the tax outcome.
Here are the typical scenarios:
Spousal Beneficiary – Continuation: If your spouse is your beneficiary, they have a special option: they can continue the annuity contract in their own name, deferring taxes further. This is often called a “spousal continuation.” The surviving spouse essentially steps into your shoes as the owner – no immediate tax is triggered at your death. The annuity keeps growing tax-deferred, and the spouse will pay taxes only when they withdraw or annuitize subsequently. This is a unique benefit for spouses; it’s similar to how a spouse can roll over an IRA. It means a married couple can effectively stretch the tax deferral across both lifetimes.
Non-Spouse Beneficiary: A non-spouse (say your child or another heir) cannot continue the contract indefinitely. The IRS requires that the entire annuity be distributed within a certain timeframe. Specifically, under IRC §72(s), a non-spouse beneficiary generally has two main choices:
Five-Year Rule: Take distributions such that the entire contract value is paid out within five years of the owner’s death. This could mean one lump sum or multiple withdrawals, as long as by the end of the fifth year, nothing remains. In practice, many beneficiaries in this scenario just take a lump sum or perhaps a few installments, which means all earnings become taxable pretty quickly.
Life Expectancy Payments: Alternatively, start receiving at least annual payments based on the beneficiary’s life expectancy, beginning within one year of the date of death. This is akin to “stretching” the annuity, somewhat like an inherited IRA’s stretch provisions (though note, unlike inherited IRAs which now under the SECURE Act often must be drained in 10 years for most non-spouses, non-qualified annuities still allow life expectancy payouts in many cases). If the beneficiary chooses this, the annuity is essentially annuitized (or a similar systematic withdrawal) over their lifetime. Each payment will be part taxable (earnings) and part tax-free (principal) based on an exclusion ratio relative to the inherited contract. This spreads out the tax hit rather than taking it all at once.
Immediate Lump Sum: The beneficiary can always just take the death benefit as a lump sum immediately. In that case, all the gain in the contract becomes taxable at once to the beneficiary. For a non-spouse, this is essentially the same result as the five-year rule but faster – they’ll owe income tax on the difference between the contract value and the deceased’s basis in the annuity. One silver lining: there is no 10% early withdrawal penalty on death distributions. Even if the beneficiary is 30 years old, if they inherited grandma’s annuity, they can cash it out without any additional 10% penalty – the penalty is waived in case of death. They just owe the normal income tax on the gains.
Multiple Beneficiaries: If more than one beneficiary inherits, the contract is usually split and each beneficiary’s share is treated separately under the above rules. Each could choose lump sum or stretch for their share. The key is the original contract’s earnings get allocated and taxed accordingly.
Estate as Beneficiary: If an estate or trust (non-see-through) is the beneficiary, often the five-year rule is the only option (since an estate doesn’t have a life expectancy). Trust situations can get complex; if a trust is named, typically the insurance company will work with the trustee, but generally the tax must be resolved within five years unless the trust immediately passes it to an individual beneficiary who can then stretch.
One thing to understand: No step-up in basis. Unlike stocks or real estate that get a step-up in cost basis at death (so heirs might avoid tax on unrealized gains), annuities do not receive a step-up in basis when the owner dies. The original investment and untaxed earnings keep their character. This means if you had $50k of untaxed gain, that $50k is going to be taxable to someone eventually, either your beneficiary or your estate. This is why some estate planners consider large non-qualified annuities somewhat tax-inefficient for heirs compared to other assets – because the tax deferred gain is essentially “prefunded” ordinary income that must be recognized.
In summary, upon the death of the annuity owner, any deferred tax liability doesn’t vanish; it transfers to the beneficiary. Spouses can defer it further (continuing the deferral), non-spouses have to pay it within 5 years or over their life expectancy. Proper planning (like naming the right beneficiary and considering the beneficiary’s tax bracket and preferences) can help manage the impact. We’ll address some planning tips and pitfalls around this later on.
Special IRS Rules and Considerations
Beyond the core principles above, there are some special rules and situations to be aware of for non-qualified annuities:
Non-Natural Owners (IRC §72(u)): Annuities are designed for individuals. If a non-qualified annuity is owned by a “non-natural” person (like a corporation or certain kinds of trusts), the tax-deferred treatment no longer applies. Instead, the annuity’s earnings are taxed each year as ordinary income to the owner. (Exceptions exist for trusts or entities acting as an agent for a natural person, and for certain immediate annuities funding structured settlements or retirement plans.) The rule is basically to prevent corporations from using annuities as tax shelters. For most individual investors this isn’t an issue, but be cautious if you ever consider placing an annuity inside a company or a non-grantor trust – you could lose the tax benefit.
1035 Exchanges: Section 1035 of the tax code allows you to exchange one annuity for another without triggering taxes. This is a very useful tax-planning tool. For instance, if you have an older annuity with high fees or poor investment choices, you can transfer the funds directly into a new annuity policy (with potentially better features) without it counting as a withdrawal. It’s essentially a rollover – the old contract is directly replaced by the new one, and the tax-deferred status continues uninterrupted. Important: To qualify, the exchange must be done insurer-to-insurer; you can’t take possession of the cash in between. And it must be an annuity to annuity (you can also 1035 exchange life insurance to annuity, but not annuity to life insurance generally). Using a 1035 exchange means you won’t pay taxes at the time of exchange; instead, the new annuity carries over the old cost basis and gain. Eventually, when you withdraw from the new contract, you’ll pay tax as usual on earnings – but you avoided an earlier tax hit by exchanging.
Partial Annuitization (Revenue Procedure 2011-38): Historically, if you tried to annuitize part of an annuity and leave the rest deferred, the tax treatment was tricky. But current rules allow a partial annuitization of a non-qualified annuity. For example, you could take half your contract and annuitize it for lifetime income, while leaving the other half growing tax-deferred. The IRS permits you to calculate an exclusion ratio for the annuitized portion separately. This gives more flexibility in retirement planning – you can get some guaranteed income (with tax-advantaged treatment on each payment) while still keeping some funds liquid for later use or inheritance.
Loans or Collateralizing an Annuity: Generally, you cannot take loans from a non-qualified annuity (unlike some life insurance policies). If the contract does allow a loan or you somehow use the annuity as collateral for a loan, it can be considered a distribution for tax purposes. In other words, the IRS doesn’t let you avoid tax by “borrowing” your gains out. They would treat that as if you withdrew it. This situation is uncommon (most annuities don’t permit loans at all).
Cost Basis Tracking: Keep records of your contributions (premiums) into the annuity. Over many years, especially if you added money over time or reinvested after withdrawals, tracking the cost basis is important. The insurance company will usually do this and report correctly, but errors can happen. If you ever withdraw or when your beneficiary claims the annuity, knowing the correct basis ensures you don’t overpay on taxes. For instance, if you think your entire withdrawal is taxable but in fact part of it was your own after-tax money, you’d want to exclude that. Typically, Form 1099-R from the insurer will show the taxable amount, which reflects basis, but it’s good to verify, especially if any unusual transactions occurred.
No Capital Loss Deductions: If the market tanks and your annuity loses value, you can’t claim a capital loss as you might with stocks. For example, if you invested $100k and the market value drops to $80k and you surrender it, you get your $80k and typically you have a $20k loss in economic terms. Unfortunately, tax-wise, you generally can’t deduct that loss for a personal-use annuity. (There is a narrow exception: if an annuity is completely worthless or maybe if surrendered for less than basis, some have tried to claim a miscellaneous itemized deduction, but those are limited and often disallowed since personal losses aren’t deductible). So, while gains are taxable, losses aren’t helpful at tax time. That’s one reason to think carefully about surrendering an annuity that’s underwater – you might forfeit the chance for it to recover, and you don’t even get a tax consolation prize.
Now that we’ve covered the federal landscape in detail, it’s time to zoom out and look at state taxes. Federal rules determine whether something is taxed, but state rules determine if your state will take an extra cut of that taxable income. State taxation can significantly impact your net outcome, especially if you live in a high-tax state or a state with retiree-friendly exemptions.
State Taxation of Non-Qualified Annuity Income (Why Location Matters)
The taxation of non-qualified annuity distributions doesn’t end with the IRS. States can also tax annuity income, and each state has its own approach. Most states start with the federal taxable income as a baseline. That means if your annuity payout was taxable federally, it’s usually taxable for state income tax unless the state has a specific exclusion or adjustment.
Here are some general points before we dive into specifics:
States With No Income Tax: If you live in a state with no personal income tax (such as Florida or Texas), then you won’t owe state tax on your annuity withdrawals at all. Seven states (and a few others with limited taxes) fall in this bucket, which can make a huge difference in your total tax liability.
States That Exempt Retirement Income: Many states consider retirement income (pensions, IRA distributions, annuities, etc.) favorably. Some fully exempt certain types of retirement income, while others allow a deduction or exclusion of a portion of it (often depending on age or income level). Non-qualified annuity income sometimes qualifies as “retirement income” for these purposes, especially if taken after a certain age.
States That Fully Tax: Quite a few states simply tax annuity income as ordinary income with no special breaks (aside from not taxing Social Security). If you reside in one of these, whatever taxable amount shows up on your federal return from the annuity will also be taxed at your state’s income tax rate.
State Taxation on the Principal Portion: Remember, the principal portion of an annuity payout isn’t taxed federally. States also do not tax return-of-principal, because it’s not in federal AGI. So state considerations only matter for the taxable (earnings) portion of your distributions.
State Age Requirements: Often, states say the exclusions apply only for those above a certain age (commonly 59½, 62, 65, etc., depending on the state) or for those who are retired. If you take annuity income early, those exclusions might not apply, making the income fully taxable by the state.
To give you a comprehensive view, the following table summarizes how each of the 50 states (for residents) treats non-qualified annuity income on the state income tax level. This assumes the annuity payouts are taxable income federally (i.e., representing earnings portion). We’ll note major exemptions and exclusions. Keep in mind state laws can change, so always double-check current rules for your state, but this provides a solid overview:
| State | State Tax Treatment of Non-Qualified Annuity Distributions |
|---|---|
| Alabama | Taxes annuity income as ordinary income. (Note: Pension income is exempt, and for IRA/401k distributions, first $6,000 is exempt for age 65+, but personal non-qualified annuities don’t qualify for those specific exemptions.) |
| Alaska | No state income tax – annuity withdrawals are not taxed at the state level. |
| Arizona | Taxed as ordinary income. (Arizona has no broad retirement income exclusion, except a small exemption for some public pensions; non-qualified annuity earnings are fully taxable by the state.) |
| Arkansas | Partially exempt: Arkansas excludes the first $6,000 per year of retirement income (including annuity distributions) for each taxpayer. Any annuity income above $6k is taxed at ordinary state rates. |
| California | Taxed as ordinary income at California’s state rates. (California offers no special exclusion for private retirement or annuity income; all taxable annuity earnings are fully state-taxable.) |
| Colorado | Generous retirement exclusion: Colorado allows those age 55-64 to exclude up to $20,000, and those 65+ to exclude up to $24,000 of retirement income (including annuities) annually. Any excess annuity income beyond those amounts is taxed at the flat state rate. |
| Connecticut | Taxed as income, but with an income-limited exclusion: Connecticut is phasing in an exemption for pension and annuity income. If your federal AGI is below certain thresholds (~$75k single / $100k joint), up to 100% of annuity income may be exempt. Above those thresholds, annuity income is fully taxable by CT. |
| Delaware | Partial exclusion: Residents 60 or older can exclude up to $12,500 of pension and annuity income. Under 60 can exclude up to $2,000. Annuity income above those amounts is taxed at Delaware’s ordinary income tax rates. |
| Florida | No state income tax – no state tax on annuity distributions. (Florida is a retiree haven in this regard.) |
| Georgia | Large retirement exclusion: Georgia allows taxpayers age 62-64 to exclude up to $35,000 of retirement income (each), and 65+ to exclude up to $65,000 each. Annuity income counts toward this exclusion. Amounts above the limit are taxed at GA’s state rates. |
| Hawaii | Favorable to pensions, but non-qualified annuity income is taxable. (Hawaii exempts many pension benefits, but since a non-qualified annuity isn’t an employer pension, its taxable distributions are generally subject to Hawaii’s income tax.) |
| Idaho | Taxed as ordinary income. (Idaho offers retirement exclusions mainly for certain public pensions; most private annuity income is fully taxable.) |
| Illinois | No tax on retirement income such as pensions, IRA, 401k distributions. However, non-qualified annuities not part of such plans are generally not exempt, meaning taxable portion of annuity withdrawals is taxed under Illinois’ flat income tax. (Illinois basically excludes “IRS-taxable retirement income” – an individually purchased annuity might not meet that definition unless it’s part of a retirement plan.) |
| Indiana | Taxed as ordinary income. (Indiana has a flat state tax and no special exclusion for private annuity income, aside from a small credit for seniors with low retirement income.) |
| Iowa | New for 2023+: Iowa exempts retirement income (including annuities) for those age 55 or older. That means qualifying annuity payouts are not subject to Iowa income tax. (If under 55, annuity earnings would be taxed ordinarily.) |
| Kansas | Taxed as ordinary income. (Kansas exempts Social Security (depending on income) and certain public pensions, but offers no special break for private annuity income.) |
| Kentucky | Partial exemption: Kentucky allows up to $31,110 (as of current law) per person in pension and annuity income to be excluded from state tax. Any taxable annuity income beyond that cap is subject to KY tax. |
| Louisiana | Partial exemption: Louisiana exempts up to $6,000 per year of pension or annuity income for individuals age 65+. (This is per taxpayer.) Annuity income beyond $6k (or if under 65) is taxed normally by the state. |
| Maine | Taxed as ordinary income. (Maine provides an exemption for pension income up to a limit (~$10,000) but only for qualified pensions; non-qualified annuity income is typically fully taxable after the federal calculation.) |
| Maryland | Partial, but tricky: Maryland has a pension exclusion (around $34,300 for 2024) for those 65+ or disabled, but it applies only to qualified retirement plans and annuities from employment (like 401k, 403b, pensions). It does not apply to annuities purchased with after-tax money on your own. Therefore, most non-qualified annuity earnings are taxable in MD, unless it’s an annuity originating from an employer plan rollover. Maryland also offers an extra $1,000 senior income exemption, but that’s minor. |
| Massachusetts | Taxed as ordinary income. (MA does not tax Social Security or MA public pensions, but it taxes private retirement distributions fully. Non-qualified annuity earnings are included in taxable income.) |
| Michigan | Partial/age-based: Michigan’s taxation of retirement income depends on your birth year. Generally, those born before 1952 get significant exclusions for pension/annuity income (often around $20k single / $40k joint, or more if only pension income). Younger retirees get less or no exclusion on private retirement income. So, some annuity income may be exempt if you qualify, but if not, it’s taxable. (It’s complex: for many under a certain age, MI taxes annuity income fully; for older folks, a chunk can be tax-free.) |
| Minnesota | Taxed as ordinary income. (Minnesota has a tax subtraction for Social Security and maybe small credits, but generally taxes pension and annuity income, especially private, fully as income.) |
| Mississippi | Retirement income exempt: Mississippi does not tax qualified retirement income or annuities for individuals age 59½ or older. This means if you are 59½+, distributions from a non-qualified annuity are typically exempt from MS state tax. (If taken before 59½, they might be taxed as regular income by MS.) |
| Missouri | Partial exclusion: Missouri allows an exclusion for Social Security and public pensions, and also for private pensions/annuities up to $6,000 per taxpayer, provided income limits are met. Many retirees with moderate income can exclude up to $6k of annuity income; beyond that (or for high earners), annuity income is taxed. |
| Montana | Taxed as ordinary income. (Montana taxes most retirement income fully, but provides a modest exemption that phases out at moderate income levels. Effectively, many will find their annuity income taxable in MT, except possibly a small exclusion if low income.) |
| Nebraska | Taxed as ordinary income. (Nebraska is known to tax retirement income fully, though they recently began phasing out tax on Social Security. Non-qualified annuity earnings are fully taxable.) |
| Nevada | No state income tax – annuity distributions are not taxed at state level. |
| New Hampshire | No general income tax: New Hampshire has no tax on wages or ordinary income. It does tax interest/dividend income (currently 4% and phasing out by 2027). Annuity payments are generally not classified purely as “interest” or “dividends” by NH law, so most annuity income is effectively not taxed in NH. (Bottom line: NH residents typically pay no state tax on annuity withdrawals.) |
| New Jersey | Partial exclusion if low-to-moderate income: New Jersey taxes retirement distributions but offers a large retirement income exclusion for those under certain income thresholds (~$100k). For qualifying taxpayers, a significant portion (up to 100% in some cases) of annuity income can be excluded. If income is above the threshold, annuity income is fully taxable by NJ. (NJ does not tax Social Security, but does tax annuities/pensions if you don’t qualify for the exclusion.) |
| New Mexico | Taxed as ordinary income. (NM has historically taxed most retirement income fully; however, starting 2022, NM introduced an exemption for some retirement income up to $10k for low-income seniors. Still, generally expect annuity earnings to be taxed in NM.) |
| New York | Partial exclusion: New York allows residents age 59½ or older to exclude up to $20,000 per year of pension or annuity income from state taxes (this applies to each spouse separately if filing joint). Any taxable annuity income above $20k is subject to NY income tax. (Note: Public pensions are fully exempt in NY, but that doesn’t apply to private annuities.) |
| North Carolina | Taxed as ordinary income. (NC eliminated its retirement income exclusion for most taxpayers some years ago, except for certain government retirees with special provisions. Therefore, non-qualified annuity income is generally fully taxable in NC state income.) |
| North Dakota | Taxed as ordinary income. (ND has relatively low income tax rates and no special exemption for private retirement income, so annuity earnings are taxed normally.) |
| Ohio | Taxed as ordinary income, but small credits: Ohio doesn’t exclude annuity income outright, but it provides a small retirement income tax credit (max $200) if you received retirement income, and an extra senior credit for age 65+. These credits slightly reduce tax but are not large. In essence, most of your annuity income is still taxed by OH, just offset marginally by credits. |
| Oklahoma | Partial exclusion: Oklahoma allows an exclusion of up to $10,000 for retirement distributions if from a public source or certain pensions. It also allows excluding some federal civil service and military pensions. However, purely private annuity income usually doesn’t qualify except possibly if it was an employer pension annuity. So, many non-qualified annuity payouts are fully taxable in OK, unless meeting a narrow exception. |
| Oregon | Taxed as ordinary income. (Oregon taxes most retirement income fully, with the main exception of federal pension which has a subtraction for pre-1991 service. Non-qualified annuities have no special break and face one of the higher state tax rates in OR.) |
| Pennsylvania | Retirement income generally not taxed: Pennsylvania is very friendly to retirees. It exempts all retirement income, including annuity payments, for individuals who have met retirement conditions (usually meaning you’re above 59½ or officially retired). So if you receive payouts from a non-qualified annuity after age 59½ (or after retirement), PA does not tax them. (If someone took an early distribution before retirement age, it might be taxable, but typically annuity income for retirees is fully exempt in PA.) |
| Rhode Island | Taxed as ordinary income. (RI taxes annuity and pension income, though they have started offering a modest exclusion for retirement income for certain filers at lower incomes. But in general, expect to pay state tax on any taxable annuity earnings.) |
| South Carolina | Partial exclusion: South Carolina provides a Retirement Deduction. Those under 65 can deduct up to $3,000 of retirement income (including annuities) each year; those 65 or older can deduct up to $10,000 of retirement income or use a broader $15,000 senior deduction (which covers any income). So effectively, at least $3k-$10k of annuity income can be tax-free, and any remaining taxable portion is taxed at SC’s rates. |
| South Dakota | No state income tax – annuity income not taxed by the state. |
| Tennessee | No state income tax – Tennessee has no income tax on wages or retirement income (its tax on interest/dividends was fully phased out by 2021). Annuity withdrawals are not subject to TN tax. |
| Texas | No state income tax – no tax on annuity distributions. |
| Utah | Taxed as ordinary income, but with a credit: Utah provides a limited retirement tax credit (around $450 for those under certain income thresholds) which can apply against annuity income. However, there’s no specific exclusion, so most annuity earnings are taxed at Utah’s flat 4.85% rate minus any small credit you qualify for. |
| Vermont | Taxed as ordinary income. (Vermont taxes retirement income fully, except Social Security for lower incomes. It has no special deduction for annuities or pensions beyond that, so annuity earnings are taxed.) |
| Virginia | Taxed as ordinary income, with age deduction: Virginia offers an Age Deduction of $12,000 for seniors 65+ (subject to income limits). If your income is moderate, you might get up to that amount off, which can indirectly cover some annuity income. If income is above the limit (~$75k single), the deduction phases out to zero. Thus, many higher-income retirees in VA will find their annuity income fully taxable. |
| Washington | No state income tax – annuity income is not taxed by WA. |
| West Virginia | Taxed as ordinary income (for private annuities). (WV exempts Social Security and up to $8k of military or certain public pensions, but private annuity income generally doesn’t get a special break beyond regular brackets.) |
| Wisconsin | Taxed as ordinary income. (Wisconsin exempts Social Security and has some targeted military exemptions, but private annuity income is fully taxable by WI’s progressive income tax.) |
| Wyoming | No state income tax – no state tax on annuity income. |
(Note: The above summary assumes you’re a resident of the state in question. If you’re a non-resident receiving annuity income, typically you pay tax to your state of residence, not where the insurance company is. And if you move states, annuity income usually becomes taxable by your new home state in the year you receive it.)
As you can see, your state of residence can make a big difference. For instance, a $30,000 annuity withdrawal that’s taxable could incur $0 in state tax in Florida, but perhaps around $2,000+ in state tax in California or New York (depending on brackets and exclusions). States like Pennsylvania or Mississippi would levy $0 if you’re of retirement age, whereas states like New Jersey or Illinois might tax or not tax depending on specific criteria. It’s a lot to digest, but the key takeaway is: check your own state’s rules or consult a tax advisor, because planning opportunities (like timing distributions or considering a relocation in retirement) might reduce your overall tax hit on annuity income.
Next, let’s weigh the overall pros and cons of using non-qualified annuities, especially focusing on their tax advantages and disadvantages, and discuss some planning insights.
Pros and Cons of Non-Qualified Annuities
| Pros 🟢 | Cons 🔴 |
|---|---|
| Tax-deferred growth: Earnings grow without annual taxation, accelerating compound growth. | Earnings taxed as ordinary income: Withdrawn gains don’t get capital gains rates, potentially resulting in a higher tax rate on investment growth. |
| No contribution limits: Invest any amount; not capped like 401(k) or IRA contributions. | 10% early withdrawal penalty: If you access earnings before age 59½, you’ll pay a 10% IRS penalty on top of regular taxes (with limited exceptions). |
| Partial tax-free withdrawals: Original after-tax principal comes out tax-free. Annuitized payments use an exclusion ratio to give a tax-free portion each time. | No step-up in basis at death: Beneficiaries owe taxes on the decedent’s untaxed gains; the entire tax-deferred growth is eventually taxable to someone. (Other assets like stocks might escape tax via step-up, but not annuities.) |
| Flexible payout options: Can take lump sums, periodic withdrawals, or lifetime income. Annuitization can provide steady income with a tax advantage on each payment. | Potentially high fees/surrender charges: Many annuities come with fees (insurance costs, investment fees) and surrender penalties. While not taxes, these reduce net returns and liquidity, indirectly affecting the product’s value. |
| No RMDs for non-qualified annuities: You’re not forced to take distributions at a certain age (tax deferral can continue as long as you want, unlike qualified plans). | Complex tax rules: The web of LIFO, exclusion ratios, and varying state laws can be confusing. Mistakes in timing or method of withdrawal can lead to higher taxes than necessary. |
| Estate planning advantages: Can name a beneficiary directly; spousal continuation allows deferral to spouse; avoids probate. | Taxable to heirs: While annuities avoid probate, heirs will pay income tax on any gains. This can be less favorable than inheriting a Roth IRA (tax-free) or life insurance (generally tax-free). |
| Creditor protection: In many states, annuity assets are protected from creditors and lawsuits. (This is a non-tax pro, but worth noting.) | Inefficient for short-term needs: If you need to access funds in the short run, the tax deferral benefit is minimal and you might face penalties. Annuities work best when held for the long term. |
Tax Planning Insights: From the above, you can gather a few strategies. If you’re primarily concerned with tax-efficiency, consider how a non-qualified annuity stacks up against other investment options: for example, long-term capital gains and qualified dividends (in a brokerage account) can be taxed as low as 0-15% for many investors, whereas annuity gains eventually hit your ordinary income bracket which could be higher. The annuity’s benefit is deferral – if you plan to hold it for decades and be in a lower tax bracket in retirement, it can pay off. But if you anticipate being in a high bracket or you value the stepped-up basis for your heirs, you might lean toward other vehicles.
On the flip side, annuities shine in providing lifetime income. The exclusion ratio means part of that income is tax-free, effectively stretching out your basis nicely. And there’s no requirement to start taking income at a certain age, giving you flexibility to defer until it makes sense (for example, delay until you’re retired and in a lower bracket, or move to a tax-friendly state).
Always weigh these pros and cons in light of your personal financial picture. Now, let’s highlight some common mistakes people make with annuity taxation and how you can avoid them.
Avoid These Common Mistakes 🚫
Even savvy investors can stumble over annuity tax rules. Here are some common mistakes to avoid when dealing with non-qualified annuities, so you don’t end up with an unexpected tax bill or penalty:
Assuming “tax-deferred” means “tax-free”: Don’t fall into the trap of thinking that because your annuity grows tax-deferred, you’ll never owe taxes. Reality: You will owe taxes on the earnings when you withdraw. Some people mistakenly treat annuity withdrawals as if they were just moving money from savings – only to be surprised by a 1099-R and a hefty tax liability. Always remember the deferred tax bill lurking under the surface.
Withdrawing too much too soon: Taking large lump-sum withdrawals from an annuity can push you into a higher income tax bracket and possibly trigger the 10% early withdrawal penalty if you’re under 59½. This one-two punch (high taxes + penalty) can erode your gains. Avoidance tip: If you need funds, consider taking smaller withdrawals over multiple years, or better yet, plan to use annuity money after you’ve retired (and are over 59½ and possibly in a lower bracket).
Ignoring the LIFO rule: Some annuity owners try to “just take out what I put in” first, not realizing the IRS’s last-in, first-out rule will make their withdrawals taxable until all gains are out. If you pull, say, 50% of your account, don’t expect 50% of that to be tax-free principal unless your gain was less than that proportion. Solution: If your goal is to access principal with minimal tax, you might explore annuitizing a portion or doing a 1035 exchange into an annuity that allows free withdrawals of basis (some contracts structure payouts creatively). But straightforward withdrawals won’t let you cherry-pick just your original money.
Not utilizing a 1035 exchange when switching annuities: If you decide to change annuity providers or products (maybe to get a better rate or different features), do not cash out your annuity and then buy a new one – that cash-out will trigger taxes on all the gains. Instead, use a 1035 exchange to directly transfer to the new annuity. This way, you carry over the tax deferral and avoid a taxable event. It’s a paperwork hassle but saves potentially tens of thousands in taxes.
Forgetting about the 59½ rule exceptions: On the flip side, some people unnecessarily shy away from needed withdrawals before 59½ because they fear the 10% penalty. While generally you want to avoid early withdrawals, if life happens (medical issues, disability, etc.), know the exceptions. For example, setting up substantially equal periodic payments (SEPP) can allow penalty-free early access to an annuity’s funds. It’s a long-term commitment, but it might fit certain situations where other funds are not available.
Mishandling inherited annuities: If you inherit a non-qualified annuity, a common mistake is to immediately cash it out without exploring the life expectancy payout option. Taking a lump sum will slam you with taxes on the full gain in one year. If the amount is large, that could mean a high tax bracket. Instead, consider the option to stretch the payments (if allowed) over your lifetime to spread the tax hit and potentially keep yourself in a lower bracket. Also, if you’re a spouse beneficiary, make sure you take advantage of spousal continuation rather than cashing out – it’s often a better move to defer taxes and maintain tax-deferred growth.
Naming the wrong owner or beneficiary: The titling of an annuity is crucial. A mistake like naming a non-spouse (say a child) as a joint owner or making a trust the owner without proper planning can inadvertently trigger tax issues. For example, adding a non-spouse owner can be considered a taxable gift and distribution. Or if a non-natural entity is owner, you lose tax deferral. Also, failing to name a beneficiary at all could send the annuity to your estate, forcing a quicker taxation (and possibly probate). Double-check your annuity policy: make sure the owner and beneficiary designations align with your intent and are set up for the best tax outcome (spouse as primary beneficiary if you’re married, for instance, to allow continuation).
Overlooking state tax implications: Not accounting for your state’s tax rules is another pitfall. For example, if you move from a no-tax state (Texas) to a high-tax state (say, New York) in retirement, you might inadvertently increase the state tax you’ll pay on annuity withdrawals. Conversely, some retirees retire to a state like Florida or Pennsylvania partly to avoid state taxes on their retirement income. It’s worth considering, especially if your annuity income will be substantial, how state taxes will affect it. Don’t let state taxes be an afterthought – they can be 5-10% extra cost that you might mitigate with proper planning or timing.
Buying an annuity inside an IRA (duplicate tax deferral): While not a tax mistake per se (it doesn’t cause a penalty or immediate tax), it’s often viewed as an inefficient move to buy a non-qualified deferred annuity inside a tax-qualified account like an IRA. The IRA is already tax-deferred; you don’t gain additional tax benefits from the annuity’s deferral. You still end up paying ordinary income tax on distributions (because all IRA withdrawals are taxed similarly). Essentially, you’re paying for a feature (tax deferral) you don’t need in that context. If an advisor suggests an annuity inside your IRA, be sure you’re doing it for the annuity’s other features (like lifetime income, death benefit, etc.), not for tax reasons. This is a commonly cited “mistake” because it can result in higher fees for no tax advantage.
Avoiding these mistakes comes down to understanding the rules (which you’re well on your way to, having read this far 🎓) and planning ahead. When in doubt, consult with a financial planner or tax professional who has experience with annuities – a quick check can save a costly blunder.
Key Terms and Concepts in Annuity Taxation
Before we wrap up, let’s summarize some key terms we’ve covered (and a few we haven’t explicitly named) that are essential in the context of non-qualified annuity taxation. Understanding these will reinforce your grasp of the topic and ensure you’re speaking the same language as your financial advisor or tax preparer:
After-Tax Contributions (Principal/Basis): The money you put into a non-qualified annuity, on which you’ve already paid income tax. Also called cost basis or principal. This amount is not taxed again when withdrawn. Keeping track of your basis is key for knowing what portion of withdrawals might be tax-free.
Earnings (Gain): The growth in the annuity – interest, dividends, and investment gains – that has accumulated tax-deferred. This portion has not been taxed yet and will be taxed upon distribution as ordinary income.
Ordinary Income: Income taxed according to regular tax brackets (as opposed to capital gains rates). Annuity earnings are taxed as ordinary income. If you’re in the 22% federal bracket, that’s the rate you’ll generally pay on annuity gains (plus whatever state rate applies).
Last-In, First-Out (LIFO): The IRS ordering rule for non-annuitized withdrawals from a deferred annuity. It presumes earnings (the last credited amounts) come out first. Result: initial withdrawals are fully taxable until you’ve pulled out all gains.
59½ Rule (IRC 72(q)): The rule imposing a 10% penalty on early distributions from an annuity (similar to the 72(t) rule for IRAs). Withdrawals of taxable gains before age 59½ incur a 10% additional tax unless an exception applies.
Exclusion Ratio: The fraction of each annuity payment that is excluded from income (tax-free) when you annuitize. Calculated as investment in the contract divided by expected return. It ensures you recover your basis gradually without tax, while taxing the rest of each payment.
Annuitization: The process of converting the lump sum value of an annuity into a stream of periodic payments (which can be for life or a set period). It irrevocably locks in a payout plan and invokes the exclusion ratio for non-qualified annuities.
1035 Exchange: A tax-free transfer of an annuity into a new annuity. Named after Section 1035 of the tax code. Allows you to replace or upgrade annuity contracts without current taxation, carrying over the tax basis to the new contract.
Beneficiary: The person or entity designated to receive the annuity benefits if the owner dies. For tax purposes, beneficiaries of non-qualified annuities have options (5-year rule, life expectancy payments, etc.) and responsibilities (pay tax on gains they receive). A spousal beneficiary has special rights to continue the contract.
Spousal Continuation: The provision that lets a surviving spouse assume ownership of the annuity upon the original owner’s death, maintaining tax deferral. No other beneficiary type has this option.
Section 72(u): Tax code section that says if an annuity contract is held by a “non-natural” person (like a corporation), it isn’t treated as an annuity for tax purposes – meaning earnings are taxed yearly (no deferral). It has exceptions (like for annuities inside trusts that are for an individual’s benefit).
Section 72(s): Tax code section requiring that non-qualified annuities have distribution-at-death rules (the 5-year or lifetime payout requirement for beneficiaries). This ensures the IRS eventually collects tax on deferred earnings after the owner’s death.
Private Annuity: An annuity agreement not with an insurance company, but between private parties (like a parent and child, often used in certain estate planning techniques). Private annuities have their own taxation wrinkles and are less common today, but the term is good to know. (In a private annuity, the payments received are taxed similarly with an exclusion ratio on each payment, but recent IRS regulations have made their use trickier for estate planning.)
Modified Endowment Contract (MEC): Though a MEC typically refers to life insurance, it’s worth noting in context: a life insurance policy that becomes a MEC loses its tax advantages and its withdrawals/loans follow a LIFO rule like annuities. We mention it because annuity taxation (LIFO, penalty rules) is somewhat similar to how MEC life insurance is taxed. It’s a reminder that different financial vehicles have different tax treatments if certain thresholds are crossed.
1099-R: The tax form issued for distributions from pensions, annuities, retirement accounts, etc. If you take any reportable distribution from a non-qualified annuity, expect a Form 1099-R from the insurer in January of the following year. Box 1 shows the total distribution, Box 2a shows the taxable amount (and code in Box 7 indicating if early distribution, death, etc.). Checking that taxable amount is how you confirm what portion was earnings vs. basis.
By familiarizing yourself with these terms, you’ll be better prepared to interpret statements from your annuity provider, fill out your tax returns, and discuss your strategy with professionals.
Non-Qualified vs. Qualified Annuities: A Quick Comparison
It’s worth drawing a clear line between non-qualified annuities (our focus) and qualified annuities, because the tax treatment, while sharing some similarities, has important differences:
Funding and Tax on Contribution: A qualified annuity is funded with pre-tax money as part of a retirement plan (for example, you rollover IRA funds into an annuity, or you buy an annuity inside your 401(k)). Because of that, you didn’t pay tax on that money going in, and often you even got a deduction. In a non-qualified annuity, you fund it with after-tax dollars (no deduction).
Tax on Distributions: Qualified annuity distributions are generally 100% taxable as ordinary income (except in cases where after-tax contributions were included, such as an IRA that had non-deductible contributions – then it’s prorated). Essentially, a qualified annuity is like any IRA: all funds were tax-deferred and now all pay-out is taxable (except any tiny basis portion if applicable). Non-qualified annuity distributions, as we’ve discussed, are partly taxable, partly return of basis. The exclusion of basis is a key difference – with non-qualified, you get credit for the fact you already paid taxes on the principal. With qualified, the entire distribution is usually untaxed money coming out, so it’s fully taxed now.
IRS Penalty and Rules: Both are subject to the 59½ rule and 10% early withdrawal penalty on taxable portions. Both also can be annuitized and use an exclusion ratio, but note: if it’s a qualified annuity (all pre-tax money), the exclusion ratio concept becomes trivial – your “investment in the contract” for exclusion ratio is just any after-tax contributions (often zero in a fully qualified account). So typically every dollar from a qualified annuity is taxable until any basis is recovered (just like IRA distributions pro-rata). Non-qualified annuities, in contrast, often have a significant tax-free portion in each annuity payment due to the basis.
Required Minimum Distributions (RMDs): Qualified annuities are subject to RMD rules (starting at age 73 as of current law) because they’re part of an IRA/401k etc. If you have a qualified deferred annuity and haven’t annuitized it, you may need to start pulling RMDs and paying taxes each year after 73. Non-qualified annuities have no RMD requirement – you could let it ride past 73 with no forced distributions (the only “required” distribution would be at death to beneficiaries per the 5-year rule). This gives non-qualified annuities an edge in flexibility; you won’t be compelled to take taxable distributions if you don’t need or want the money at a certain age.
Contribution Limits: Qualified annuities are constrained by the contribution limits of the retirement plan they’re in (e.g., IRA contribution limits, or 401k limits, etc.). Non-qualified have no such limit – you can put in $10k or $1 million, whatever you like and the insurer allows.
Roth Annuities: It’s worth noting there’s a variant: a Roth IRA annuity (qualified but funded with after-tax dollars and grows tax-free). If you buy an annuity inside a Roth IRA, it essentially becomes a tax-free annuity (as long as distributions are qualified under Roth rules). That’s arguably the best of both worlds tax-wise: tax-deferred growth and tax-free payouts. However, you’re limited by Roth contribution or conversion rules to get money into it. Non-qualified annuities by themselves cannot achieve tax-free status on earnings; they can only defer and then ultimately be taxed.
In summary, a non-qualified annuity sits in between a typical brokerage investment (taxable every year but often at lower capital gains rates) and a qualified retirement account (tax-deferred but fully taxable on withdrawal). It gives you deferral and partial tax-free withdrawals (principal) but hits the earnings with ordinary tax rates. Recognizing whether your annuity is qualified or not is important for tax handling – sometimes people rollover a 401k into an annuity and later confuse it for a non-qualified annuity. The paperwork and 1099-R will usually tell the story: a qualified annuity distribution 1099-R often has different codes and the provider might label the account as IRA annuity. Always clarify with your provider if unsure, because misreporting a qualified distribution as non-qualified (or vice versa) can cause tax headaches.
Entities Involved: Who Does What in Annuity Taxation
Several key players and entities have roles in the world of annuities and their taxation. Understanding who does what can help you navigate the system:
Internal Revenue Service (IRS): The IRS, of course, sets the federal tax rules. It defines how annuity income is taxed through laws (Internal Revenue Code) and regulations. The IRS expects you to report annuity income on your tax return and pay any due taxes and penalties. It also provides guidance such as IRS Publication 575 (Pension and Annuity Income) which helps taxpayers calculate taxable and non-taxable portions of annuity payments. If there are disputes (say, you and an insurer disagree on what’s taxable), the IRS regulations and perhaps Tax Court rulings are the final word. In short, the IRS is the rule-maker and enforcer in this arena.
State Tax Agencies: Your state’s department of revenue (or equivalent) sets state tax policies. They decide on any special exclusions or credits for retirement income and ensure you pay state tax on taxable annuity earnings as per state law. For example, the California Franchise Tax Board expects you to include annuity income on your CA return, while Pennsylvania’s Dept. of Revenue specifically tells retirees that their annuity income is not taxed (if qualified by age/retirement). State tax forms often have a line or worksheet for pension/annuity income adjustments. The role of state agencies is to implement state tax rules – which can significantly modify the net outcome of your annuity’s taxation.
Insurance Companies (Annuity Providers): The insurance company that issues your annuity plays a surprisingly important role in taxation administration. They track your investment (basis) and earnings inside the annuity. They apply the tax rules to any distributions you take and then report them. Each year you take a distribution, the insurer will send you and the IRS a Form 1099-R detailing the distribution. They typically calculate the taxable portion for you (especially if the annuity was annuitized or if they have record of your basis). It’s largely their responsibility to get those numbers right based on the info they have. Insurance companies also withhold taxes on distributions if you request (or if mandated for certain distributions). For instance, on a lump sum payout, you can ask the insurer to withhold, say, 20% for federal tax and maybe some % for state, so you don’t owe it all at year-end. Additionally, insurers need to comply with the 72(s) requirements for payouts after death – they often outline options for beneficiaries in accordance with IRS rules. They might notify a beneficiary: “You have 5 years to take distribution” or offer a life payout option. They also enforce the 59½ rule in terms of marking distributions with the correct code on 1099-R (though they won’t stop you from taking money out early except for contract surrender charges). Lastly, if an annuity is owned by a trust or entity, the insurance company applies 72(u) by issuing yearly taxable statements, etc. So, your insurer is both a reporter and enforcer of tax rules in practice, and a source of information – don’t hesitate to ask them for tax info about your contract.
Financial Advisors/Insurance Agents: These professionals are the ones who often recommend and sell annuities. A knowledgeable advisor should guide you through the tax implications before you purchase. They can help you decide, for instance, between a non-qualified annuity and another savings vehicle, considering your tax bracket now vs. later. Advisors also assist with strategies: e.g., possibly splitting a large annuity into two contracts for flexibility (there’s a tactic where having multiple smaller annuities can let you withdraw from one fully – paying tax on those gains – while leaving the other untouched, thereby accessing principal from one sooner; this is advanced planning to manage LIFO). They might also suggest annuitizing at the right time or doing a 1035 exchange to a newer contract with benefits. In short, financial advisors and agents act as planners and facilitators, helping you navigate the product features with an eye on tax efficiency. However, not all advisors are tax experts, so ensure advice is corroborated by a tax professional for complex situations.
Tax Professionals (CPAs, Enrolled Agents): When it comes to filing your tax return or planning withdrawals, your CPA or tax advisor is critical. They’ll take that 1099-R and put the numbers in the right spot on your 1040. If something looks off, they’ll contact the insurer for clarification. They can help with decisions like whether to take an extra distribution in December vs. January, to spread income between tax years. A tax pro also can run projections on how annuity income will impact things like Medicare premiums (MAGI calculations) or taxation of Social Security benefits, etc. If you inherited an annuity, a tax professional can illustrate the tax bite of lump sum vs stretching so you can decide wisely. Basically, they ensure compliance and optimize within the rules.
The Courts (Tax Court): While not usually directly involved in individual planning, the U.S. Tax Court (and higher courts) have decided cases that shape annuity taxation. For example, issues like what constitutes an annuity for tax purposes, or whether a certain transaction is a taxable distribution, have been litigated. There have been cases where taxpayers tried creative strategies with annuities (like private annuity arrangements or assigning annuities to others) and the courts ruled on whether those trigger tax. As a layperson or even as a typical advisor, you won’t interact with the courts, but their decisions flow into IRS rules and publications that eventually affect you. So indirectly, court cases have given us the clarity we have today on things like exclusion ratio, partial annuitizations, etc. Knowing that the tax treatment has been vetted by law can give you confidence to follow the standard approaches we’ve discussed.
Legislators and Regulators: Finally, Congress and regulatory bodies like the NAIC (National Association of Insurance Commissioners) play roles. Congress writes the tax laws (the IRS interprets them). Major changes – like a new age for penalty exceptions, or new distribution requirements – come from legislation. The SECURE Act, for instance, affected inherited IRAs, but one day Congress could also adjust rules for non-qualified annuities (though nothing major has changed recently aside from allowing partial annuitization). The NAIC and state regulators, while more focused on consumer protection and insurance company solvency, can influence how annuity products are structured (which in turn can have tax effects; e.g., certain long-term care annuity hybrids have special tax treatment). Keeping an ear out for any tax reform discussions is wise because retirement and investment taxation is often on the table.
In summary, the IRS and state tax authorities set and enforce the tax rules; insurance companies implement and report the taxable events; advisors and tax professionals help you navigate and comply with these rules in your personal strategy; and overarching all that, lawmakers and courts shape the rules we operate within. Understanding these roles can help you know where to turn if you have questions: e.g., call your insurer for basis info, ask your CPA about state tax nuances, consult an advisor for planning moves, etc.
In-Depth Examples of Annuity Taxation in Action
Let’s solidify our understanding with a few concrete scenarios. These examples will show how the rules translate into real-life numbers and decisions:
| Scenario | Tax Outcome |
|---|---|
| 1. Partial Withdrawal (Gain First): You invested $50,000 in a deferred annuity; it’s now worth $80,000 (so $30k is gain). At age 60, you withdraw $20,000 as a one-time partial withdrawal. | Because of LIFO, the $20k is deemed to come from the $30k gain first. Taxable amount: $20,000 as ordinary income. You’ll owe income tax on $20k at your marginal rate. (Your cost basis remains $50k, of which $30k is still in the contract unrecovered.) No 10% penalty since you’re over 59½. |
| 2. Larger Withdrawal Exceeding Gain: Same $80k annuity (basis $50k). You withdraw $40,000 in a lump sum. | The first $30k of that withdrawal is taxable earnings (exhausting the gain). The remaining $10k comes from your principal. Taxable amount: $30,000; Tax-free amount: $10,000. No penalty if age ≥59½. After withdrawal, the contract is worth $40k, which is now all your principal (so future withdrawals of that remaining $40k would be tax-free until any new gains accumulate). |
| 3. Annuitization into Lifetime Income: Your non-qualified annuity is worth $100,000. You annuitize at age 65 into a lifetime monthly payment of $600. Let’s say your calculated exclusion ratio is 50%. | Each month, $300 of that $600 is tax-free return of basis, and $300 is taxable income. Over a full year, you’d receive $7,200 total, report $3,600 as ordinary income on your tax return, and $3,600 is excluded. No 10% penalties (life annuity payments are exception to early withdrawal rules). If you live long enough that the total tax-free amount paid equals your $100k basis, subsequent payments become fully taxable. |
| 4. Early Withdrawal (Under 59½): At age 50, you take a $10,000 withdrawal from a non-qualified annuity that has $8,000 of gain portion left in it. | Taxable amount: $8,000 (the earnings part of the withdrawal, per LIFO). That $8,000 will be subject to ordinary income tax plus a 10% penalty ($800) because you’re under 59½. The remaining $2,000 of the withdrawal is return of basis (no income tax, no penalty on that part). Effective result: you pay tax on $8k + an extra $800 penalty. |
| 5. Inherited Non-Spouse, Lump Sum: You inherit your father’s non-qualified annuity worth $75,000. His original investment was $50,000 (so $25k gain). You opt to take the entire $75k as a lump sum distribution. | Taxable amount to you: $25,000 as ordinary income (the gain is taxable to the beneficiary). No early withdrawal penalty applies, regardless of your age, because withdrawals due to the owner’s death are exempt from the 10% penalty. You will include $25k in your taxable income this year. The remaining $50k of the payout is tax-free (that was your father’s basis). |
| 6. Inherited Non-Spouse, Stretch: Same scenario as above ($75k with $25k gain), but instead of lump sum, you choose to take annual payments over your life expectancy (say 15 years per IRS table for your age). | The insurance company sets up an annuity payout for you. Each year, a portion of the payout is taxable. Essentially, the $50k basis will be spread over the 15 years, and the $25k gain spread and taxed. For simplicity, roughly $\frac{25}{75} = 33%$ of each payment would be taxable if evenly distributed (actual calc will use exclusion ratio formula). No 10% penalty. You’ve effectively spread the $25k of income over 15 years, which likely keeps you in a lower bracket than taking $25k all at once. |
| 7. 1035 Exchange: You have an older annuity worth $120,000 (basis $90k, gain $30k). You want to move it to a new annuity with better terms without cashing out. | You execute a 1035 exchange directly to a new insurer. Taxable amount: $0 at the time of exchange. (No reportable distribution.) The new contract carries over $90k basis and $30k untaxed gain. When you eventually take money out of the new annuity, $30k of it will be taxable then. You successfully deferred taxes by exchanging instead of withdrawing. |
| 8. Changing Ownership (Non-Spouse): You gift your annuity (value $50k, basis $30k) to your adult daughter while you’re alive. | This triggers a taxable event to you as the original owner. The IRS treats it as if you withdrew the $20k gain and then gifted the cash. Taxable amount: $20,000 to you as ordinary income in the year of the gift. (No 10% penalty on gifts though.) Your daughter receives an annuity with a new basis of $50k (and she wouldn’t owe tax until she withdraws future earnings beyond that). Moral: transferring ownership (other than to a spouse) causes the owner to recognize any gain immediately. |
These examples highlight how different actions on a non-qualified annuity can lead to very different tax outcomes. By understanding them, you can plan your moves: for instance, seeing how spreading payments (example 6) can soften the tax blow compared to a lump sum (example 5), or why you might not want to gift an annuity during life (example 8) due to the unexpected tax bill.
Each person’s situation will have its nuances, but walking through the math like this before you act can save you from surprises. When making decisions, consider: What is my basis? How much of this distribution will be taxable? What tax bracket or penalties apply? Are there alternatives (like annuitize, 1035 exchange, or wait) that improve the outcome?
FAQs – Real Questions from People Like You
Finally, let’s address some frequently asked questions about non-qualified annuities and their taxes. These are phrased in plain language, just like folks ask on forums or to their financial advisors, with concise answers:
Q: Do I have to pay taxes on a non-qualified annuity if I don’t take any money out?
A: No. As long as you leave the money in the annuity, you won’t pay taxes on the growth until you withdraw funds or receive payments.
Q: Are annuity withdrawals taxed as capital gains or ordinary income?
A: They’re taxed as ordinary income. Any gains from a non-qualified annuity are treated like regular income, not capital gains.
Q: Can I withdraw my initial investment from an annuity without paying taxes?
A: Not immediately. Due to last-in, first-out rules, you must withdraw all earnings first (taxable) before you can get to the tax-free return of your initial investment.
Q: What happens tax-wise if I inherit a non-qualified annuity?
A: You’ll owe income tax on the deceased’s untaxed gains. You can take a lump sum (all tax at once) or stretch payments over your life (tax spread out). No 10% penalty applies.
Q: How can I avoid the 10% penalty on annuity withdrawals before 59½?
A: Use an IRS exception. Options include taking substantially equal periodic payments, waiting for disability, or only withdrawing your original basis (after all gains are out). Otherwise, penalty applies on taxable amounts.
Q: Is a non-qualified annuity a good idea for retirement income?
A: It can be. It offers tax-deferred growth and an option for lifetime income. But remember, the payouts’ earnings portion will be taxed, and consider fees and your tax bracket.
Q: Do states tax annuity income?
A: It depends on the state. Some don’t tax income at all (Florida, Texas), some exempt retirement income (Pennsylvania, Illinois for qualified plans), and others fully tax annuity earnings. Check your state’s rules.
Q: If I annuitize my contract, will I still owe taxes?
A: Yes, but only on part of each payment. A portion of each annuity payment will be tax-free (return of basis) and the rest is taxable earnings. The insurance company will tell you the taxable amount.
Q: Can I roll a non-qualified annuity into an IRA or 401(k)?
A: No, you generally can’t. Non-qualified annuities aren’t eligible for rollover into qualified retirement accounts. You can only 1035 exchange it into another annuity.
Q: Are the fees I pay on my annuity tax-deductible?
A: No, fees inside the annuity are not tax-deductible. They’re taken from the contract’s value. You can’t write them off on your taxes; they just reduce your investment’s return.