What Portion of a Non-Qualified Annuity is Taxable? Avoid this Mistake + FAQs

Only the earnings (investment gains) are taxable—your original premium payments (made with after-tax dollars) come back to you tax-free. You’re not alone if this seems perplexing.

According to a 2022 retirement industry survey, only 27% of annuity owners fully understand how their withdrawals are taxed, leaving the majority at risk of surprise tax bills or costly IRS penalties for mistakes.

In this in-depth guide, you’ll learn:

• Exactly which part of your annuity payout is taxed and why the IRS only targets your investment gains (not the principal you paid in) 😉

• Key IRS rules and formulas (exclusion ratio & LIFO) that determine the taxable vs. tax-free portions of withdrawals – including real-life examples to make it clear

• Common tax mistakes annuity holders make (and how to avoid penalties), from early withdrawal traps to misreporting income on Form 1099-R ⚠️

• Federal vs. state taxation: how state laws differ on taxing annuity income, with a state-by-state breakdown so you know if your state will take a cut

• Tax planning strategies and pros/cons of non-qualified annuities – leveraging tax deferral benefits, understanding exclusion ratios, and comparing to other retirement options to minimize your tax bite 💡

Dive in to become an authority on non-qualified annuity taxation and avoid any unwelcome surprises from the IRS!

What Portion of a Non-Qualified Annuity Is Taxable? (Quick Answer)

In a non-qualified annuity, only the earnings (interest or investment gains) are subject to income tax. Your original contributions (the principal or “cost basis” in the contract) were made with after-tax dollars, so they are not taxed again when you withdraw them.

This fundamental rule means that every dollar you receive from a non-qualified annuity is either a tax-free return of your own investment or taxable profit.

To put it simply: if you invested $100,000 into a non-qualified annuity and it grew to $150,000, the $50,000 of growth is the taxable portion.

The $100,000 you paid in can be withdrawn tax-free. The IRS doesn’t let you avoid taxes on the gains, but it also ensures you don’t pay twice on the money you originally contributed.

Why only the earnings? Non-qualified annuities are funded with after-tax money (unlike a qualified annuity inside a 401(k) or IRA, which is pre-tax). Since you received no upfront tax deduction for putting money into a non-qualified annuity, the principal is your “investment in the contract” – a term the IRS uses to denote the amount you’ve already paid tax on.

Taxation kicks in only on the interest, dividends, and capital appreciation that accumulate tax-deferred inside the annuity. When you eventually take money out, those deferred earnings become taxable ordinary income (not capital gains). Meanwhile, your original investment is returned without further tax, effectively spread out over your distributions.

Quick Example – Taxable vs. Tax-Free Portion

Let’s illustrate the taxable portion with a quick example:

¹Annuitization means converting the lump sum into a stream of payments. The exclusion ratio (explained later) determines how much of each payment is basis vs. earnings.

As shown, only the gain portion is taxable. If you withdraw incrementally, the IRS typically considers earnings to come out before principal (so the first $30k of that $80k contract withdrawal would be taxable). If you annuitize, each payment is part taxable, part tax-free in proportion to your basis. And if you surrender entirely, you pay tax on the net profit ($30k in this case) in the year of withdrawal.

Understanding Non-Qualified Annuities and Tax Basics

To confidently grasp the taxable portion, let’s quickly define what a non-qualified annuity is and how it works:

• Non-Qualified Annuity: An annuity contract not held in a tax-qualified retirement plan. You purchase it with your own after-tax funds (as opposed to a qualified annuity inside an IRA or 401(k)). “Non-qualified” simply means it doesn’t receive special upfront tax breaks for contributions. However, it does grow tax-deferred until you take money out. Insurance companies offer these as a way to create future income or savings with tax-deferral, even when you’ve maxed out other retirement accounts.

• Tax-Deferred Growth: Just like a 401(k) or traditional IRA, a non-qualified annuity accumulates earnings without yearly taxes. You won’t get a 1099 each year for interest or gains as you would with a taxable brokerage account. This tax-deferred compounding can be powerful – but the catch is you pay ordinary income tax on the earnings when withdrawn. Unlike stocks or mutual funds held outside an annuity, you don’t get the lower capital gains or dividend tax rates; the IRS taxes annuity gains at your regular income tax rate.

• Cost Basis (Investment in the Contract): This is the total premium you paid into the annuity with after-tax dollars, minus any amounts you previously withdrew that were not taxed. It’s essentially your already-taxed “skin in the game.” The importance of the cost basis is that it’s returned to you tax-free. Every distribution from an annuity is conceptually split between giving you back some of your basis and giving you some earnings. The IRS requires you to track (or have the insurer track) your basis to know how much of your money has been returned.

• Earnings: Any growth above your cost basis – interest, dividends, and investment gains inside the annuity. These earnings are the taxable portion upon distribution. They remain untaxed inside the annuity until you withdraw them, at which point they are taxed as ordinary income (not as capital gain or interest specifically, but all just “income”). It’s as if the annuity converts all types of gains into one category for tax: income.

By understanding these basics, you now know that the taxable portion of a non-qualified annuity = the portion representing earnings on your investment. The next step is to see how the IRS calculates that portion in different scenarios.

IRS Rules: How the Taxable Portion Is Calculated (LIFO & Exclusion Ratio)

The IRS has established clear rules under the Internal Revenue Code (IRC) §72 for determining how much of each annuity distribution is taxable. The calculation depends on how you take money out of the annuity. There are two primary frameworks:

1. Withdrawals Before Annuitization – LIFO Rule (Last-In, First-Out)

2. Annuitized Payments – Exclusion Ratio Method

Let’s break down each:

1. LIFO Taxation for Withdrawals and Partial Surrenders

If you take a partial withdrawal or a lump-sum surrender from a deferred annuity before turning it into a stream of payments, the IRS uses a LIFO (Last-In, First-Out) rule. This means that the last dollars into the account (the earnings) are assumed to come out first. In practice:

• Any withdrawals are deemed to come entirely from earnings until all the gain in the contract has been withdrawn. Only after you’ve taken out all accumulated interest/gains would you begin to withdraw your original principal.

This rule was instituted by Congress in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) to prevent taxpayers from abusing annuities as tax shelters. Prior to 1982, one could withdraw their original contributions first (tax-free) and leave interest to grow further untaxed — a FIFO (First-In, First-Out) method that gave a significant deferral advantage. TEFRA flipped it to LIFO for all annuities funded after August 13, 1982, ensuring the taxable earnings come out before untaxed principal.

Implication: If your annuity has, say, $40,000 of gain and you withdraw $10,000, that entire $10,000 is taxable income (because it’s coming out of the earnings “layer”). You’ll keep paying tax on withdrawals until you’ve pulled out all $40,000 of profit. Once only your original investment remains, further withdrawals of that principal would be tax-free (but typically at that point you’d just be getting your money back).

⚠️ Important: Even if you only withdraw a small amount, if your annuity has untaxed gains, those withdrawals will be taxable up to the amount of the gains. There is no concept of proportionate tax-free withdrawal (except for pre-1982 contracts) unless you annuitize.

In other words, with non-annuitized withdrawals, you can’t “just take out my original money first” – the tax code won’t allow it for modern annuities.

Example: You invested $100k, it’s now $150k. You take out $30k in a pinch. Under LIFO, that $30k is assumed to be entirely from the $50k earnings. So you’d owe income tax on $30k. Your contract would now be $120k value ($100k original + remaining $20k gain).

If you took another $20k later, that too would be taxable (using up the rest of the gain). After that, any further withdrawals would be considered return of the $100k basis (tax-free). But until you “eat through” the earnings, everything you take is taxable.

Additionally, if you fully surrender the annuity (cash it out completely), the taxation is straightforward: your taxable portion is [Account Value] – [Cost Basis]. The insurer will report that difference as taxable income on Form 1099-R. In our example, cashing out the $150k would trigger tax on $50k of ordinary income.

2. Annuitization: The Exclusion Ratio for Periodic Payments

When you annuitize a non-qualified annuity, you convert it into a guaranteed stream of payments (for example, a lifetime monthly income or payments over a fixed period). In this case, each payment you receive consists of two components:

• Return of principal – not taxable

• Earnings (interest) – taxable as income

The IRS uses an “exclusion ratio” to allocate the taxable and non-taxable portions of each payment.​

• Investment in the Contract: your net after-tax premiums (adjusted for any refunds, rebates, etc.), i.e. the principal you put in.

• Total Expected Return: the total amount the annuity is expected to pay out over the payout period. For a life annuity, this is based on your life expectancy per IRS actuarial tables; for a fixed-period, it’s just payment amount * number of payments.

The exclusion ratio (a percentage) tells you what portion of each payment is considered a return of your basis (thus excluded from taxable income). The remaining portion of each payment is taxable.

Example: Suppose you annuitize your contract valued at $200,000. You originally contributed $120,000 (so that’s your basis). You choose a fixed 20-year term certain annuitization, and the monthly payment is $1,100. Over 20 years (240 months), you will receive $1,100 * 240 = $264,000 in total.

• Your basis is $120,000.

• Expected return is $264,000.

• Exclusion ratio = $120,000 / $264,000 ≈ 45.5%.

This means 45.5% of each payment is considered your own money back, and 54.5% is earnings. Concretely, each month you get $1,100: about $500 is tax-free, and $600 is taxable income. Over 20 years, you will have received the full $120k back tax-free (500 * 240 = $120k) and paid tax on the $144k total earnings.

After 20 years, what happens? You will have fully recovered your basis. If the annuity payments stop at 20 years (term certain), there’s no further issue. If it’s a lifetime annuity and you outlive the 20-year expectancy, any further payments become 100% taxable (because your entire basis has already been excluded by then).

On the flip side, if you die before receiving $120k back, the unrecovered basis is deductible on your final tax return as a miscellaneous deduction. The tax law ensures you (or your estate) aren’t taxed on money you never got back.

Note: For lifetime annuities, the expected return is calculated using IRS life expectancy tables based on your age (and your joint annuitant’s age, if any). This is laid out in IRS Publication 939. The insurance company issuing the annuity will typically report the taxable amount of annuity payments to you each year on Form 1099-R, having computed the exclusion ratio for you when the annuity starts. But it’s good to understand how it works.

Annuitization vs. Withdrawals – Why It Matters

Choosing to annuitize versus taking ad-hoc withdrawals affects how the taxable portion comes out:

• Annuitization spreads your tax liability over many years. Each payment is partly taxable, partly not. This often results in a smoother tax outcome and can keep you in a lower tax bracket in retirement since you’re not taking all gains at once.

• Withdrawals (without annuitizing) front-load the taxes. The first dollars out are fully taxable until you’ve exhausted all gains. If you take large withdrawals, you might bunch a lot of taxable income into a single year, potentially pushing yourself into a higher marginal bracket.

Consider your needs: If you want flexibility and only withdraw occasionally, you can keep the rest deferring. But remember any chunk you take will likely be all taxable earnings first. If you want steady income and predictability (and to maximize return of basis early), annuitization might make sense, letting you recover a portion of your basis with each payment.

📌 Key Point: Regardless of method, the total taxable amount over the annuity’s life will equal the total earnings. Annuitization just changes the timing of when taxes are paid. With withdrawals, you might pay a lot of tax early and none later; with annuity payments, you pay some tax on each payment.

What About Qualified Annuities?

To avoid confusion, it’s worth noting what happens in qualified annuities (like one purchased inside an IRA or 403(b) with pre-tax funds). In those cases, the entire distribution is generally taxable (except for any after-tax contributions you may have in the account). With qualified accounts, your cost basis is often zero (or very low), because you never paid tax on that money going in. So if you have an IRA annuity, every withdrawal or payment is taxable (just like any IRA distribution). Non-qualified annuities, by contrast, have that tax-free portion equal to your basis.

This article focuses on non-qualified annuities, but keep in mind the distinction: qualified = fully taxable (in retirement) since it was pre-tax going in; non-qualified = partially taxable since it was after-tax going in. The mechanisms like exclusion ratio still apply for annuitized payouts of a qualified annuity, but the “investment in the contract” might only be any after-tax amounts (e.g., if you rolled over after-tax dollars or made nondeductible contributions).

Federal Tax Law and Regulations Affecting Annuity Taxation

Understanding the historical and legal context can further solidify why only part of a non-qualified annuity is taxable. The rules we use today are the result of specific laws and IRS regulations intended to balance encouraging retirement savings with preventing tax abuse. Here are some key points and regulations:

• Internal Revenue Code §72 – This is the main section governing annuities. It defines “gross income” inclusion for annuities and lays out the exclusion ratio formula (Section 72(b)), the LIFO rule for amounts not received as annuity (Section 72(e)), and the 10% penalty on early distributions (Section 72(q) – more on that shortly). When in doubt, tax professionals turn to IRC §72 for the authoritative word on annuity taxation.

• TEFRA 1982 (Tax Equity and Fiscal Responsibility Act) – As mentioned, this law changed partial withdrawals from FIFO to LIFO for post-1982 contracts. It was a major turning point, curbing the once-popular strategy of pulling out principal first tax-free. Fun fact: If you own a very old annuity purchased before Aug 14, 1982 (and haven’t exchanged it), the original investment portion from before that date can still come out first tax-free (grandfathered FIFO) — a rarity today.

• DEFRA 1984 (Deficit Reduction Act) – Tightened some annuity rules further and introduced the concept that assigning or pledging an annuity as collateral is treated as a taxable event (basically to prevent people from getting a loan against the annuity’s untaxed gain without paying taxes).

• Tax Reform Act of 1986 – Added that any loans against annuities (and other tax-deferred contracts) are treated as distributions. This closed another loophole where one could borrow from an annuity’s cash value tax-free. After 1986, if you take a loan from a non-qualified annuity, the amount of the loan is taxed as if you withdrew it (to the extent of gain in the contract), and if you’re under 59½, it’s also subject to penalty. In short, no sneaky tax-free cash via loans.

• SECURE Act (2019) – This primarily impacted qualified retirement accounts, but one provision indirectly affects annuities: it made it easier to offer annuities in 401(k) plans and changed inherited IRA rules. Non-qualified annuities’ inheritance rules remained under the older framework (5-year rule or life expectancy rule for beneficiaries), which we’ll mention later. The key point: SECURE Act did not change how non-qualified annuity gains are taxed, but be aware if you see annuities in IRAs, the taxation follows the qualified rules.

• IRS Regulations & Rulings – The IRS has issued various guidelines on calculating exclusion ratios and handling different scenarios. For instance, Revenue Ruling 79-220 clarifies how to apply exclusion ratio to joint and survivor annuities. Private Letter Rulings (PLRs) over the years have addressed specific questions like partial annuitizations (e.g., if you annuitize only part of the contract, how to compute taxable portion on that part vs. the remaining). Generally, each payment stream from an annuity is treated separately for exclusion ratio purposes.

• Form 1099-R Reporting – Insurance companies are required to report annuity distributions to you and the IRS. Box 2a of Form 1099-R will indicate the “taxable amount” of the distribution. In many cases for non-qualified annuities, the insurer does calculate the taxable portion (especially for full surrenders or annuity payments). Sometimes, if they cannot compute it (e.g., if they don’t have the cost basis info), the 1099-R might mark “taxable amount not determined,” leaving it to the taxpayer to figure out using IRS worksheets. Always double-check that your insurer has your correct cost basis – especially if you’ve done a 1035 exchange (tax-free transfer) from one annuity to another, as the basis carries over. A lost or incorrect basis can lead to overpaying tax (if under-reported) or IRS trouble (if you under-report taxable income).

In summary, the federal tax law ensures that non-qualified annuities enjoy tax-deferred growth but not tax-free growth. The earnings will eventually be taxed, either bit by bit or all at once, depending on how you withdraw. Keeping good records and understanding these rules will help you avoid paying more tax than necessary or facing penalties.

Common Mistakes in Annuity Taxation (and How to Avoid Them)

Even seasoned investors can slip up when it comes to the nuanced tax rules of annuities. Here are some frequent mistakes and misconceptions regarding the taxable portion of non-qualified annuities – and tips on how to dodge them:

Mistake 1: Assuming the Entire Withdrawal Is Tax-Free or Fully Taxable

Some people mistakenly believe either all annuity withdrawals are tax-free (wrong – only principal is) or all are taxable (also wrong – you get credit for your basis). This confusion can lead to unpleasant surprises.

• Avoidance Tip: Remember the golden rule – only earnings are taxed. If you withdraw an amount less than or equal to your gains, it’ll be fully taxable. If you’ve taken all gains already, the rest is tax-free. And if you annuitize, use the exclusion ratio concept. When in doubt, have the insurer or a tax advisor help determine the split. Check your 1099-R forms; they often tell you how much is taxable.

Mistake 2: Not Tracking Your Cost Basis

Over many years, especially if you made multiple contributions or did 1035 exchanges into new annuities, you might lose track of your total after-tax contributions. If you don’t know your cost basis, you risk overstating taxable income (paying tax on more than just the gain).

• Avoidance Tip: Keep all records of annuity purchases, additional premium deposits, and any taxable withdrawals taken. When you do a 1035 exchange (a tax-free swap from one annuity to another), ensure the new insurer records the carryover basis correctly. Verify that the basis on your statements or forms is right. You can request a basis letter or history from the insurance company if needed. It’s easier to fix errors before you start withdrawals than to fight with the IRS later.

Mistake 3: Ignoring the 59½ Rule and Penalties

One expensive trap is taking taxable withdrawals from an annuity before age 59½ without understanding the consequences. The IRS generally imposes a 10% early withdrawal penalty (similar to early IRA distributions) on the taxable portion of any distribution taken before 59½. This penalty is in addition to the regular tax on the earnings.

• Example: You’re 55 and take a $20,000 withdrawal. If $20k is considered earnings (taxable), and you’re in the 24% tax bracket, you’d pay $4,800 income tax plus a $2,000 penalty (10%). That’s $6,800 gone – an effective 34% bite.

• Avoidance Tip: Plan to leave annuity funds untouched until you’re at least 59½. If you must access money earlier, see if you qualify for an exception to the penalty. Exceptions under IRC §72(q) include: becoming disabled, certain distributions made as part of a series of substantially equal periodic payments (SEPPs), or if the annuity owner has passed away (beneficiaries don’t pay the 10% penalty, though they do pay taxes on gains). Always consult a tax advisor if considering early withdrawals; sometimes a short-term loan or other source is better than raiding the annuity and paying penalties.

Mistake 4: Thinking Annuity Gains Get Capital Gains Treatment

This is a crucial misunderstanding: People sometimes assume the growth in their annuity might be taxed as long-term capital gain (15% rate) or that if the annuity invested in stocks, for instance, the gain might be treated like stock gains. Not so.

• Clarity: All taxable distributions from a non-qualified annuity are taxed as ordinary income, not capital gain, regardless of the source of the earnings. The IRS treats the annuity as a tax-deferred wrapper that converts all inside gains into ordinary income on the way out. This means even if your annuity was invested in equity subaccounts (in a variable annuity) or took advantage of long-term bond interest, you don’t get preferential rates. The trade-off for tax-deferred compounding is potentially higher taxation on the back end.

• Avoidance Tip: When planning, factor in that annuity earnings could be taxed at your highest marginal rate. It might still be worth it if you’ll be in a lower bracket in retirement, or if tax deferral significantly grew your balance. Just don’t bank on capital gains rates. If having preferential tax treatment on investments is important to you, consider that when allocating assets between annuities and regular accounts.

Mistake 5: Gifting or Transferring a Non-Qualified Annuity Without Considering Taxes

If you decide to transfer ownership of your non-qualified annuity to someone other than your spouse – say, giving it to an adult child or into a non-spousal trust – you might inadvertently trigger an immediate tax event. Under IRS rules, assigning a non-qualified annuity to another person is treated as if you withdrew it for tax purposes (to the extent of gains). This is a less-known pitfall.

• Example: You want to gift your $100k annuity (with $30k gain) to your child. The act of gifting will cause you to have $30k of taxable income reported to you (and possibly a 10% penalty if you’re under 59½), even though you didn’t pocket a dime. Essentially, the IRS treats it as you realizing the gain at the time of transfer. The child then gets a new basis equal to the contract’s value at that time ($100k).

• Avoidance Tip: Don’t transfer ownership (except to a spouse or in a divorce) without understanding the tax impact. An exception in the tax code allows spousal transfers without triggering tax (including if you name your spouse as new owner or if it’s transferred in a divorce settlement). But any other gift or assignment – even to a revocable trust in some cases – can be a taxable event. If you intend to change ownership or gift the annuity, consult a tax professional to plan it properly, or consider doing a 1035 exchange into an annuity that better suits the new owner after you’ve accepted the tax hit, if that’s part of estate planning.

Mistake 6: Failing to Account for State Taxes

We’ll discuss state-by-state differences soon, but a common oversight is not realizing that state income taxes may also apply to the taxable portion of your annuity withdrawals. People might move in retirement for tax reasons but forget that their current state might tax their annuity payouts.

• Avoidance Tip: Check how your state treats annuity income. Some states fully exempt retirement income or have exclusions that can cover annuity payments (especially for those over a certain age), whereas others tax it like any other income. Plan withdrawals in light of both federal and state taxes. (If you’re considering relocation, this could be a factor – e.g., moving from a high-tax state to a no-tax state before taking large distributions.)

By steering clear of these mistakes – understanding the taxability of each portion, minding age-based rules, and keeping good documentation – you can confidently manage your non-qualified annuity and avoid giving Uncle Sam any more than necessary.

Examples: How Much Tax Will You Pay on Your Annuity?

To cement the concepts, let’s walk through a few concrete scenarios showing the taxable portion in different situations. These examples will combine the ideas of basis, earnings, LIFO, and exclusion ratio:

Example 1: Lump Sum Withdrawal (Deferred Annuity, No Annuitization)

• Scenario: Maria, age 62, invested $80,000 into a non-qualified fixed annuity 10 years ago. It’s grown to $100,000. She wants to withdraw $30,000 to help buy a vacation home.

• Analysis: Maria’s gain in the contract is $20,000 ($100k value – $80k basis). Under LIFO, the first $20k of her $30k withdrawal is considered earnings and taxable. The remaining $10k of that withdrawal dips into her basis and is tax-free.

• Result: She will owe ordinary income tax on $20,000. Because she’s over 59½, no 10% penalty applies. After the withdrawal, her annuity’s value might drop to about $70k. Her remaining cost basis in the contract is now $70k as well (because $10k of her original basis was returned to her). Going forward, if she takes more out, there’s no gain left – so any further withdrawals would actually be tax-free until gains build up again. The insurance company will send her a 1099-R showing $20k taxable.

Example 2: Full Surrender of Contract

• Scenario: John, age 58, has a variable annuity he purchased for $50,000 that is now worth $75,000. He decides to cash it out entirely to reinvest elsewhere.

• Analysis: John’s gain is $25,000. Because it’s a full surrender, he doesn’t have to worry about partial withdrawal ordering – it’s straightforward: $25k is taxable. Also, John is under 59½, so the $25k taxable portion is subject to a 10% early withdrawal penalty (unless an exception applies).

• Result: John will have $25,000 added to his taxable income this year, and owe a $2,500 penalty on top. The insurer will withhold taxes if John requested (or as required for early distributions) and send him a 1099-R for the distribution. Notably, if John had any after-tax contributions beyond the initial $50k (for example, some contracts allow periodic additional contributions), those would raise his basis and reduce the taxable amount. But here it’s just initial principal vs gain.

Example 3: Annuitization – Lifetime Income

• Scenario: Linda, age 65, has a non-qualified annuity worth $300,000. Her cost basis (premiums paid) is $200,000. She decides to annuitize the full amount into a single-life immediate annuity, which will pay her $1,800 per month for life.

• Analysis: Based on her age, let’s say the IRS life expectancy table projects Linda will live another ~20 years. Expected return = $1,800 * 12 * 20 = $432,000 (this is the total amount the annuity is expected to pay). Her basis is $200,000.

  • Exclusion ratio = 200,000 / 432,000 ≈ 46.3%. So 46.3% of each payment is excluded from tax.

  • Each monthly payment $1,800: Tax-free portion ≈ $833; Taxable portion ≈ $967.

• Result: Each year, Linda will receive $21,600 in payments, and about $11,600 of that will be taxable income. She will pay taxes gradually on the $100k of gain (actually $300k – $200k = $100k gain; total expected taxable portion over her lifetime is $232,000 since expected return 432k minus basis 200k – that $232k is more than her actual $100k gain because life expectancy overshoots the actual gain; however, if she indeed lives the expected length, she will effectively have been taxed not only on gain but also on part of principal; the magic is if she dies early, she under-recovers basis but gets a deduction). If Linda lives well past 85 (exceeding the expected return period), once she has received $200k tax-free (which will happen after about 11.5 years of payments), the exclusion ratio no longer applies and 100% of each further payment becomes taxable. In essence, from that point on she’s gotten all her basis back and is just receiving additional “gains” (funded by the insurer pooling mortality risk). If Linda unfortunately passes away earlier than expected, say after receiving $150,000 total (of which $69,450 was tax-free basis returned), then her remaining unrecovered basis ($200k – $69,450 = $130,550) can be taken as a deduction on her final tax return (it’s a miscellaneous deduction not subject to the 2% floor, per IRS rules).

Example 4: Inheritance – Beneficiary’s Taxable Portion

• Scenario: Raj had a non-qualified annuity worth $120,000 at his death, with a cost basis of $90,000 (so $30k gain). His daughter Mina is the beneficiary and takes a lump-sum distribution of the death benefit.

• Analysis: In non-qualified annuities, the beneficiary inherits the contract value, but the IRS does not step-up the basis like they would for stocks or real estate. Mina will owe income tax on the portion of the annuity that represents earnings. Here, that’s $30,000. Because this was a death payout to a beneficiary, the 10% early withdrawal penalty does not apply (even if Mina is under 59½). But she does have to include $30k in her income for the year.

• Result: Mina may choose instead to stretch the payments (if the contract and laws allow, she could take distributions over her life expectancy to spread the tax) or to cash out immediately. Either way, someone pays the tax on the gains – either gradually or at once. Had Raj named his spouse instead, the spouse could continue the annuity in her own name and postpone taxes further (a special spousal continuation provision). But as a non-spouse, Mina’s options are either the 5-year rule (withdraw all funds within 5 years) or take at least annual distributions over her life expectancy (thus using an exclusion ratio if annuitized or just paying tax on earnings via withdrawals).

These examples underscore that while the taxable portion is always the earnings, the timing and manner in which you (or your beneficiaries) withdraw funds can greatly affect how and when that tax is paid. You can use these principles to plan in a tax-efficient way.

Pros and Cons of Non-Qualified Annuity Taxation

Like any financial product, non-qualified annuities have unique tax advantages and disadvantages. It’s helpful to weigh these pros and cons side-by-side:

In short, the tax deferral of non-qualified annuities is a compelling benefit for long-term investors (especially if you expect to be in a lower tax bracket later, or you want investments to grow unhindered by yearly taxes). However, one must be mindful of the eventual tax cost – gains will be taxed as income, which could be a larger bite than, say, long-term capital gains from a mutual fund. The lack of contribution limits and the ability to partially control the timing of taxes (via withdrawals vs annuitization) give annuity owners some flexibility that other accounts might not. On the downside, early liquidity comes with tax friction, and the rules require careful navigation.

State Taxation: Will Your State Tax Your Annuity Payout?

So far, we’ve focused on federal tax rules for annuities, which apply uniformly across the U.S. However, state income taxes can also apply to annuity income, and these rules vary widely by state. Some states treat annuity distributions the same as any other income, while others offer special breaks for retirement income (which can include payouts from annuities).

Let’s outline how state taxation generally works for non-qualified annuities:

• If your state has a general income tax, it will typically tax the taxable portion of your annuity distributions just as the IRS does (at your state income tax rate). However, many states have exemptions or exclusions for certain retirement income (pensions, IRAs, annuities) especially for seniors.

• A number of states have no personal income tax at all, meaning annuity income is completely tax-free at the state level.

• Some states exempt all or most retirement income (often defined as distributions from pensions, IRAs, 401(k)s, and annuities) once you reach a certain age or regardless of age.

• Some states provide a partial exemption: e.g., the first $X of retirement income is tax-free, or they tax retirement income only above certain amounts or for certain types (public pensions vs private, etc).

• If you’re receiving annuity payments, they are generally considered pension or retirement income in many state codes, but specifics matter. Non-qualified annuities might not always be explicitly named in state statutes, yet they usually fall under “annuity” or “pension” categories if used for retirement.

Below is a state-by-state breakdown of how annuity income is taxed. This assumes you are a resident of that state when receiving the income. (Non-residents typically don’t owe state tax to the state where an insurance company is located; it’s based on your resident state taxation of overall income.)

State Tax Treatment of Non-Qualified Annuity Income:

• Born before 1946: Generous exemptions – up to $56,961 (2023) of pension/annuity income per taxpayer can be exempt, and Social Security and military pensions are fully exempt.

• Born 1946 to 1952: Smaller exemption (around $20,000 single/$40,000 joint) for retirement income, and only available once reaching age 67 (with a trade-off of giving up Social Security exemption).

• Born after 1952: Generally, no special pension/annuity exemption (aside from Social Security and military, which remain exempt). So younger folks will have to pay MI’s flat ~4.05% on annuity income.

• These rules are complex; but for many MI retirees, a significant chunk of annuity income may be exempt if they’re older; for younger, it’s taxable. | Minnesota | Taxable (minor subtraction) – Minnesota taxes annuity income fully. It has a small subtraction/credit for some retirement income and Social Security depending on income levels, but no broad exemption for pensions or annuities (except some military pension exclusion). Expect to pay MN’s state income tax on your taxable annuity payouts. | | Mississippi | Exempt – Mississippi is very retiree-friendly: It exempts all qualified retirement income. That includes pensions, IRAs, 401ks and annuity payments if they are part of a retirement plan. In practice, MS tax law treats income from annuities as non-taxable as long as the withdrawal is a “normal retirement” distribution (after age 59½ or due to death/disability or part of a retirement plan). So typically, annuity payouts are tax-free in Mississippi (similar to how Social Security is exempt). Early withdrawals might be treated differently, but generally MS residents do not pay state tax on retirement annuity income. | | Missouri | Partially Exempt (income-limited) – Missouri offers a pension exemption up to $6,000 for private pensions/annuities per taxpayer, if income is below certain limits ($85k single/$100k married AGI for full exemption; phases out above). Social Security and public pensions have larger exemptions (up to full for Social Security). So a portion of your annuity income might be exempt if your income isn’t too high; otherwise, MO will tax the rest at its normal rates. | | Montana | Mostly Taxable – Montana taxes annuity income as ordinary income. There is a very limited exemption (around $4,880) for pension/annuity income, which phases out at moderate income levels (starting around $37k). Practically, many retirees in MT end up paying state tax on most of their annuity income. | | Nebraska | Taxable (phasing changes) – Nebraska currently taxes annuity and pension income fully, but it’s worth noting they recently started to phase out taxation of Social Security (not yet pensions/annuities). Unless future law changes include annuities, assume your annuity payouts are taxable by Nebraska. | | Nevada | No Income Tax – Nevada has no state income tax. Your annuity earnings face no state tax bite. | | New Hampshire | No Earned Income Tax – New Hampshire doesn’t tax wages or typical retirement income. It historically taxed interest and dividends, but as of 2027, that too is phased out (it’s gradually reducing its 5% interest/dividends tax to 0%). Annuity payouts are not considered “interest or dividends” in the NH tax sense, and New Hampshire has no broad income tax, so annuity income is not taxed in NH. (Even before the phase-out, annuity distributions were generally not subject to the interest/dividend tax, which targeted investment income like stock dividends and bank interest.) | | New Jersey | Partially Exempt (income-limited) – NJ offers a generous pension exclusion for those age 62 or older: up to $75,000 (single) or $100,000 (joint) of retirement income (pensions, annuities, IRA distributions) can be excluded if gross income is under $150,000. If income > $150k, no exclusion. So many middle-income retirees can receive their annuity income state-tax-free up to those limits. If you qualify, a large portion or all of your non-qualified annuity income may be exempt in NJ. NJ also doesn’t tax Social Security and has separate exclusions for military pensions. | | New Mexico | Partially Exempt (limited) – New Mexico recently introduced an exclusion for retirement income: up to $8,000 per person (65+) in 2022, increasing to $15,000 by 2025, for those with income below $100k single/$150k joint. So a portion of annuity income can be exempt. Beyond that, NM taxes the rest at its income tax rates. (NM also fully exempts Social Security for middle/lower income and all for 65+ starting 2024.) | | New York | Partially Exempt – New York allows retirees age 59½ or older to exclude up to $20,000 of pension or annuity income per year (per spouse). This famously includes private annuities and IRAs. Any annuity income above $20k (or if under 59½) is taxed at NY’s rates. Note: Public pensions and Social Security are fully exempt in NY. But your non-qualified annuity payments would utilize the $20k exclusion and then be taxable after that. | | North Carolina | Taxable (for most) – North Carolina used to have some exclusions, but after tax law changes, it now taxes most private retirement income fully (flat 4.75% rate). Exceptions: NC still honors a complete exemption for federal and NC government pensions for those with 5+ years of service as of 1989 (the Bailey settlement) – not applicable to private annuities. So assume your annuity gains are taxed by NC. Social Security is exempt. | | North Dakota | Taxable – North Dakota taxes annuity payouts fully as income (though ND’s top rate is relatively low). ND doesn’t have special retirement exclusions except a credit for Social Security tax. So count on state tax for non-qualified annuity income. | | Ohio | Taxable (small credits) – Ohio does not specifically exempt private pension or annuity income, except a rather small $200 credit for retirement income if over a certain age, and a separate credit for those 65+ (max $50). In essence, the vast bulk of annuity income is taxed by Ohio’s income tax. (Military pensions are fully deductible, but private annuities are not). | | Oklahoma | Partially Exempt – Oklahoma allows an exclusion of $10,000 per individual for retirement benefits (including annuities), or you can exclude 100% of federal civil service retirement if choosing that instead. So most can take up to $10k off the top of annuity income from state tax each year. Amounts above that are taxed. (Joint filers each get $10k if each has retirement income). | | Oregon | Taxable (with some credits) – Oregon taxes private retirement income fully. There’s a retirement credit available for low-income seniors and some exclusions for federal pensions for those who earned benefits pre-1991. But generally, non-qualified annuity distributions are subject to Oregon’s high income tax. Social Security is exempt, but annuities don’t get a break unless you qualify for the specific limited credits. | | Pennsylvania | Exempt (for retirement distributions) – Pennsylvania is one of the most generous: It exempts all retirement income for those age 59½ or older. This includes annuity payments, whether from qualified or non-qualified plans, as long as you’re above 59½ (or meet the IRS definition of retirement distribution, e.g., death/disability). If you take an early withdrawal before 59½ that doesn’t meet an exception, PA might tax it. But normal annuity payouts in retirement are not taxed by PA. (PA does, however, tax certain early distributions or non-retirement distributions as interest/dividends). | | Rhode Island | Partially Exempt (income-limited) – RI has a relatively new break: starting a few years ago, Rhode Island allows a $15,000 retirement income exemption for those 65+ if your federal AGI is below certain limits ($95k single/$150k joint). That can cover annuity income. If you qualify, $15k of your annuity payouts would be tax-free; any remainder is taxed at RI’s rates. | | South Carolina | Partially Exempt – South Carolina provides generous retirement income deductions. By default, anyone under 65 can deduct $3,000 of retirement income. At age 65+, that jumps to $15,000 per taxpayer (that can cover annuity, IRA, pension income). Moreover, SC allows an alternative approach: retirees can deduct up to $10,000 of qualified retirement income (like an IRA/401k distribution) in addition to a smaller general deduction. But for non-qualified annuities, likely the general $15k applies after 65. End result: much annuity income can be sheltered in SC, especially for married couples (each can deduct $15k). Above that, it’s taxed by SC. Social Security is fully exempt in SC. | | South Dakota | No Income Tax – South Dakota has no state income tax. No tax on annuity distributions. | | Tennessee | No Income Tax – Tennessee used to tax interest/dividends (Hall Tax), but as of 2021 that’s fully repealed. Now TN has no personal income tax on any earnings, so annuity income is not taxed. | | Texas | No Income Tax – Texas has no state income tax. Your annuity’s taxable portion is of no concern to Texas – it’s all tax-free at the state level. | | Utah | Taxable (with retiree credit) – Utah taxes annuity income at its flat 4.95% rate, but it provides a tax credit for retirement income. For those born before 1953, a credit up to $450 (single) / $900 (joint) is available, phasing out at higher incomes. For those born in 1953 or after, Utah instead has a Social Security credit but not a specific pension credit. So younger retirees will basically pay full Utah tax on annuity income; older ones get a small credit. | | Vermont | Taxable – Vermont fully taxes annuity distributions as income. VT does have an exclusion for Social Security (for low-income filers) but no exclusion for other retirement income. Expect to pay Vermont’s income tax on your taxable annuity gains. | | Virginia | Taxable (limited age deduction) – Virginia doesn’t specifically exempt annuity or pension income except for a now mostly phased-out age deduction. Taxpayers 65+ can claim an age deduction (max $12,000), but it’s reduced dollar-for-dollar by income over a threshold (~$75k single). Many retirees with moderate incomes don’t get it. So in practice, most annuity income is taxed in VA. (Social Security is not taxed in VA, however.) | | Washington | No Income Tax – Washington State has no personal income tax, so no tax on annuity income. | | West Virginia | Taxable (with some breaks) – West Virginia taxes private annuity income. They offer a $8,000 exclusion for civil and military pensions and are phasing out taxation of Social Security by 2022, but for non-qualified annuities, there’s no broad exclusion. So expect WV tax on those earnings. (Note: WV has been improving retiree taxation, but as of now private annuity income is still taxed.) | | Wisconsin | Taxable (some exemptions) – Wisconsin taxes annuity and pension income, but it does exempt Social Security and has full exemptions for military and government pensions for those who qualify. There’s no general private pension exclusion (Wisconsin used to allow one long ago, but not anymore, except to some very old public employees). Thus, non-qualified annuity distributions are generally part of taxable income in WI. | | Wyoming | No Income Tax – Wyoming has no state income tax. Annuity income is not taxed by the state. |

(Note: Tax laws can change, and some details (like exact dollar amounts or birth-year rules) may update. Always check the latest state tax regs or consult a CPA for current info relevant to your situation.)

As you can see, the state landscape ranges from no taxes at all, to partial relief, to fully taxed. For example, if you’re in Florida or Texas, you won’t owe state tax on that annuity money, period. In Pennsylvania or Illinois, state law gives you a full pass on retirement income, which includes annuities. Meanwhile, in states like California or New York, you’ll pay substantial state income tax on annuity gains (after modest exclusions in NY).

This state-by-state knowledge is crucial for planning. It might influence where you choose to retire or how you budget for annuity income. If you live in a high-tax state and have a large annuity, you might consider taking advantage of any exclusions (e.g., splitting annuity income with a spouse to each use an exclusion, timing your retirement move, etc.). Also, if you move states, generally the taxation will apply based on your resident state in the year you receive the income (some states prorate part-year residents).

Bottom line: Check your state’s rules. Federal tax might take the biggest chunk, but state taxes can nibble (or take a big bite) out of your annuity payouts too.

Tax Strategies to Minimize the Taxable Portion and Tax Impact

While you can’t avoid paying taxes on the earnings portion of a non-qualified annuity forever, you can strategize to lessen the tax pain and optimize your financial outcome. Here are some tax planning tips and strategies related to annuities:

• Timing of Withdrawals: Plan your withdrawals or annuity start date for when you’re in a lower tax bracket. For many, that’s in retirement when you have less wage income. Delaying withdrawals until after you stop working (and after 59½ to avoid penalties) can mean those taxable earnings are hit at a lower marginal rate. Conversely, avoid taking large taxable distributions in a single year if it could push you into a higher bracket—consider spreading them over multiple years.

• Partial Annuitization: You don’t have to annuitize the whole contract at once. Some contracts and current tax rules allow for partial annuitization. This means you could convert a portion of your annuity into a lifetime (or fixed term) income stream (getting exclusion ratio benefits on that part), while the rest stays deferred. This can create a blend of some steady partially-tax-free income and some continued tax deferral. Each portion’s taxes are calculated separately. This strategy gained clarity after an IRS ruling in 2011 that explicitly allowed partial annuitizations with exclusion ratio treatment on the annuitized part.

• Use of 1035 Exchanges: If your annuity no longer suits you (high fees, poor performance, or you want different features), you can exchange it for another annuity (or even some life insurance contracts) tax-free under IRC §1035. While this doesn’t directly change the taxable portion, it can allow you to reposition into, say, an annuity with income riders or lower costs, which might affect how and when you draw money. Note: A 1035 exchange preserves the basis and gain; it doesn’t reset anything for taxes. Also, if you have a pre-1982 annuity (FIFO withdrawal treatment) and you 1035 exchange it, you typically carry over the pre-82 status on that portion, but be careful with such legacy benefits when exchanging.

• Taking Advantage of the Exclusion Ratio: If you desire income, consider annuitizing at least a portion to utilize the exclusion ratio. Especially if you have a large gain, annuitization can prevent a massive one-time tax hit and instead give you a tax-advantaged income stream. The exclusion ratio effectively lets you front-load the return of basis in earlier payments. If you don’t expect to need lump sums and are comfortable with the loss of liquidity, annuitization can be a smart tax play.

• Multiple Contracts to Ladder Income: Some people purchase multiple smaller annuities instead of one large one. Why? This can offer flexibility to annuitize or withdraw each at different times. For example, annuity A could be turned on at 65 for income, while annuity B continues to defer until 70. This way, you control the flow of taxable income more precisely. It also could help manage tax brackets—turn on just enough income to fill a lower tax bracket, leave the rest deferred.

• Charitable Remainder Trust (CRT) Strategy: For very high net worth individuals with large annuities who are charitably inclined, one approach is to donate the annuity to a CRT. This can avoid immediate taxes, provide an income stream (with favorable tax character) to you for life, and then leave the remainder to charity. This is a complex strategy, but it essentially moves the annuity out of your estate and allows the trust to handle the tax (the trust, being tax-exempt, won’t pay tax on the annuity cash-out; you get an income and a charitable deduction potentially). This requires legal and tax expertise to implement. But it’s worth mentioning as a method to avoid that big income hit on highly appreciated annuities while fulfilling philanthropic goals.

• Annuitize Before Moving to a High-Tax State: Since the exclusion ratio locks in a tax-free portion of each payment, if you plan to move to a state with high income taxes, consider starting your annuity income while you are in a low-tax state so that the basis portion is already determined for each payment. This way, the state can only tax the smaller taxable portion of each payment, not an entire withdrawal. If instead you moved and then took a lump sum, the new state could tax the whole gain at once.

• Use Gains for Qualified Expenses if Possible: If you’re under 59½ and absolutely need to use annuity money, see if you qualify for exceptions like using the funds for certain medical expenses (if exceeding IRS AGI thresholds), or consider the 72(t)/72(q) series of substantially equal periodic payments to avoid the 10% penalty. This doesn’t remove the income tax but can save you that penalty.

• Plan for Heirs: If leaving an annuity to heirs, note that they will owe taxes on the gains. If your beneficiaries are in much lower tax brackets than you, it might be fine to let them take the payouts and pay the tax. However, if they’re in higher brackets, you might strategize to withdraw some annuity funds yourself at a lower rate and invest them elsewhere or gift money (paying tax now at your rate to spare them later). Alternatively, sometimes converting a large gain annuity to a life annuity + period certain can ensure a beneficiary continues to get payments after your death (they’ll still be taxed on the earnings portion of those, but it’s spread out). Some advanced planning with an advisor can optimize the situation.

• Monitor Legislative Changes: Tax laws can change. For instance, proposals have floated to potentially change the taxation of investment income or even tax some of the build-up in annuities for very wealthy taxpayers (though currently life insurance and annuities enjoy deferral). Stay informed, especially if you have significant assets in annuities, so you can adapt if new laws alter the landscape.

In essence, controlling the timing and manner of your annuity distributions is the key to minimizing taxes. Non-qualified annuities give you latitude – you decide when to take income (unlike, say, required minimum distributions on qualified plans, which, notably, do NOT apply to non-qualified annuities during the owner’s life). Use that flexibility to your advantage. Deferral is your friend for growth, but once you need the money, consider options like gradual annuitization or spreading withdrawals to avoid spikes in taxable income.

Lastly, consulting with a financial planner or tax advisor is wise before making big moves. They can run projections to show how different withdrawal or annuitization strategies will impact your tax bill over time.

Definitions of Key Terms (Glossary)

To wrap up, here’s a quick reference glossary of key terms we’ve discussed, for clarity:

• Non-Qualified Annuity: An annuity not held within a qualified retirement plan. Funded with after-tax dollars, offering tax-deferred growth and partially taxable withdrawals.

• Qualified Annuity: An annuity contract inside a tax-qualified account (IRA, 401(k), etc.), funded with pre-tax contributions or rollovers. Entire distribution usually taxable (since no initial tax was paid on contributions).

• Cost Basis (Investment in Contract): The amount of money you contributed to the annuity with after-tax dollars. This portion is returned to you tax-free.

• Earnings (Gain): The growth on your annuity (interest, dividends, capital gains within the contract) that has not yet been taxed. This portion becomes taxable upon distribution.

• Tax-Deferred: Tax on earnings is postponed until a later date (when you withdraw). The annuity’s hallmark feature is tax-deferred accumulation.

• LIFO (Last-In, First-Out): The rule that for non-annuitized withdrawals, the last money into the contract (earnings) comes out first. Ensures taxable earnings are withdrawn before any tax-free principal.

• FIFO (First-In, First-Out): Opposite of LIFO. Relevant only to pre-1982 annuity contributions which can be withdrawn first (tax-free). Not applicable to modern contracts.

• Annuitization: Converting the annuity’s value into a stream of periodic payments (often for life or a fixed period) under the contract’s terms. This triggers the use of an exclusion ratio for taxes.

• Exclusion Ratio: The percentage of each annuity payment that is excluded from gross income (i.e., not taxable) because it represents return of principal. Calculated as investment in contract divided by expected return.

• 1099-R: The IRS tax form issued for distributions from pensions, annuities, retirement accounts, or insurance contracts. It details total withdrawals and the taxable amount.

• 59½ Rule: The age before which most retirement distributions (including annuity gains) incur a 10% early withdrawal penalty on the taxable portion, barring exceptions.

• 10% Penalty (IRC §72(q)): The additional tax penalty applied to taxable annuity distributions taken before age 59½ (similar to 72(t) for retirement plans). Exceptions include death, disability, certain periodic payments, etc.

• 1035 Exchange: A tax-free transfer of an annuity contract’s value into a new annuity (or certain life insurance/long-term care contracts), allowed by IRC §1035. Avoids current taxation on gains by carrying over basis and tax-deferred status to a new policy.

• Beneficiary Continuation (Stretch Annuity): When a non-qualified annuity owner dies, a non-spouse beneficiary can continue the contract by taking distributions over their life expectancy (or 5-year rule), thus stretching the tax impact out. A spouse beneficiary can assume ownership and treat it as their own annuity.

• STEPPED-up Basis: (Not applicable to annuities) – Unlike stocks or real estate, annuities do not receive a stepped-up basis at death. The gain portion remains taxable to beneficiaries. This is a key estate planning consideration.

Understanding these terms will help ensure you fully grasp the discussion and can communicate effectively with financial professionals about your annuity.

Frequently Asked Questions (FAQs)

Q: Is the principal in a non-qualified annuity ever taxable?
A: No – your principal (the money you put in) is not taxable upon withdrawal because you funded it with after-tax dollars. Only the earnings portion of distributions is taxed.

Q: How do I figure out the taxable amount of each annuity payment I receive?
A: Use the exclusion ratio. Your insurer typically calculates this: they divide your after-tax contributions by the expected total payments to get the non-taxable percentage of each payment. The rest is taxable.

Q: If my annuity earns interest, do I pay tax on the interest each year?
A: No, not annually. In a non-qualified annuity, interest and earnings accumulate tax-deferred. You pay taxes on that interest only when you withdraw it (or start receiving annuity payments that include those earnings).

Q: Are annuity withdrawals taxed as capital gains or ordinary income?
A: As ordinary income. Even if the annuity’s growth came from investments that would normally be capital gains, once inside an annuity, all earnings are taxed at regular income tax rates upon withdrawal.

Q: Do I have to pay state taxes on my annuity income?
A: It depends on your state. Some states don’t tax retirement income at all (or have no income tax), while others tax annuity payouts fully. Many states offer partial exemptions for retirement income or for seniors. Check your state’s rules or see the table above for guidance.

Q: What happens if I withdraw from my annuity before age 59½?
A: The taxable portion of that withdrawal will incur a 10% IRS penalty on top of regular income tax, unless you qualify for an exception (such as death, disability, or certain periodic payment arrangements).

Q: Is a death benefit from a non-qualified annuity taxable to beneficiaries?
A: Yes. Beneficiaries must pay income tax on the gain in the contract that they receive. However, they don’t pay tax on the deceased’s principal. The insurance company will report the taxable amount to them. (No 10% penalty applies to inherited annuity distributions.)

Q: Can I exchange my annuity for another without paying taxes on the gains?
A: Yes, through a 1035 exchange. You can transfer your annuity’s value into a new annuity (or certain other insurance products) without current tax, as long as the new contract is in the same owner’s name. The tax-deferred status continues in the new policy.

Q: If I annuitize, can I later change my mind and cash out the annuity?
A: Generally no. Once you fully annuitize and start a lifetime or term income, you typically give up access to the lump sum. You receive payments as agreed, and cannot revert to a withdrawal of the remaining account value (since there technically isn’t an “account value” anymore in many contracts). Some modern annuities offer partial annuitization or flexible payout options, but a full annuitization is usually irrevocable.

Q: How are annuity payments taxed if I have a joint-and-survivor annuity with my spouse?
A: The exclusion ratio is calculated based on both lives’ expectancies. Each payment has a fixed non-taxable portion. If one spouse dies and payments continue to the survivor, the same exclusion ratio often applies until the basis is fully recovered, after which remaining payments become fully taxable.

Q: I have an old annuity purchased decades ago. Are there any special tax rules I should know about?
A: Possibly. If it’s pre-1982, withdrawals might use FIFO (principal first) for the portion of basis from before that date. Also, very old contracts might not have the 10% penalty (if before 1982). It’s worth reviewing with a tax advisor – you could have grandfathered benefits.

Q: Do I need to take Required Minimum Distributions (RMDs) from a non-qualified annuity?
A: No. RMDs apply to qualified retirement accounts (IRAs, 401(k)s, etc.). Non-qualified annuities have no RMD rules – you can defer withdrawals indefinitely during your life (though after death, beneficiaries have distribution requirements).

Q: If I move to another state, which state taxes my annuity income?
A: Generally, your state of residence when you receive the payment will tax that income. If you move from a high-tax state to a no-tax state (or vice versa), your annuity payments will be taxed (or not) according to the rules of your new state for the year you receive them.

Q: Can I deduct any annuity losses?
A: If your annuity ends up being worth less than your cost basis (e.g., you surrender for less than you put in, which can happen with certain variable annuity investments or fees), you may be able to claim a loss on your tax return. Typically it’s a miscellaneous itemized deduction (subject to rules) or a capital loss in some cases. This area is tricky – consult a tax advisor. But yes, losses aren’t ignored by the IRS, though deductibility has limits.

Q: What portion of each annuity payment is taxable for a qualified annuity (like one in an IRA)?
A: In a qualified annuity, usually 100% of each payment is taxable (since no part of it was previously taxed). The exception would be if you had any after-tax contributions in the account (basis) – then each payment would have a small non-taxable part calculated by a similar method. But most often, with a traditional IRA or 401k annuity, it’s all taxable.

Q: Are there any ways to eliminate taxes on my annuity gains entirely?
A: Realistically, the only way to have tax-free annuity gains is to use the annuity within a Roth IRA (qualified annuity funded with Roth money, where distributions can be tax-free) or to leave the annuity to a charity (where you don’t pay tax but you also don’t keep the money). Otherwise, for non-qualified annuities, taxes on gains are deferred but not forgiven. With planning, you can reduce and spread out the impact, but not completely eliminate it for personal use.