Are annuities taxable? Rules on withdrawals and income

When saving for the future, accurate earnings projections are key. That’s why your long-term financial security can depend on understanding how taxes affect your retirement accounts.

Annuities are often described as tax-beneficial, which leads many savers to wonder how they’re treated by the IRS. They may also wonder: Are annuities taxable?

The short answer is yes, but the details vary. Read on to find out how the IRS treats different types of annuities and discover common taxation misconceptions. The more you learn, the better prepared you can be when crafting the ideal investment portfolio for your goals.

What are annuities and how do they work?

Annuities are long-term contracts with insurance companies. You contribute to the annuity with either a lump sum or periodic payments, and the balance can grow in the account through interest or market-linked earnings. You decide when to withdraw money or convert the balance into steady annuity payments.

These products are popular among retirement savers. Fixed annuities can offer predictable growth and tax-deferred earnings. You can put money away for many years and then either take a lump-sum payout or receive a series of regular income-style payments in retirement.

Does an annuity count as income?

When annuities pay out, the IRS treats them as a form of income. But determining whether annuities are taxed as ordinary income depends on the contribution style and type of annuity. 

In some cases, the IRS taxes a complete withdrawal, and in others, only a portion because you’ve already paid taxes on a part of the money in the account. And in rare cases, withdrawals can be tax-free. In the following section, we’ll cover the details of each of these scenarios.

How are annuities taxed?

Annuity taxation depends on factors like whether you have a qualified or non-qualified annuity and the type of interest you earn. Below, we explore the ins and outs.

How qualified annuities are taxed

A qualified annuity is funded with pre-tax dollars, meaning your contributions move directly from your paycheck to the annuity without first being taxed by the IRS. This structure can low your current tax burden but can increase future taxable income.

It’s misleading to think of a qualified annuity as a tax-free annuity. You don’t have to pay taxes on annuity savings during the accumulation period. But you will pay income tax on both principal and earnings when you withdraw money. 

How non-qualified annuities are taxed

Non-qualified annuities are funded with after-tax dollars. Contributions you make are from income or savings that the IRS has already taxed. When you withdraw your savings from a non-qualified annuity, the IRS only taxes your interest earnings using a calculation known as the exclusion ratio.

How fixed and variable annuities are taxed

Fixed annuities have a locked-in interest rate. They can provide predictable growth, which is ideal for projecting total future savings. Variable annuities can produce higher earnings, but they fluctuate with the market and carry risk of losses during an economic downturn. 

These different types of accounts don’t change how your annuity is taxed. The IRS determines taxation based on whether it’s a qualified vs. non-qualified annuity. 

How immediate and deferred annuities are taxed

Immediate annuities begin making payouts soon after you deposit money in the account. Deferred annuities can distribute your savings at a later date, often in retirement. 

So how are annuity payments taxed for these models? Both immediate and deferred annuities can be qualified or non-qualified, and tax rules follow how you put money in the account — pre-tax vs. after-tax dollars. 

The main difference is timing. Immediate annuities generate taxable income right away. Deferred annuities allow tax-deferred growth for many years before you begin withdrawing money. 

How Roth annuities are taxed

Roth annuities have a uniquely tax-beneficial structure. They’re funded with after-tax dollars. So long as the account has been open for 5 years and you’re over age 59½, you won’t pay any taxes on withdrawals, not even on interest.

How are inherited annuities taxed?

Even if you don’t save money in an annuity, you could end up with one as part of an inheritance. When an annuity holder dies, their beneficiaries may receive money saved in the account, and the following taxation rules apply.

Qualified vs. non-qualified inherited annuities

When you inherit a qualified or non-qualified annuity, you pay taxes on withdrawals just as the original account holder would have. The entire amount withdrawn from a qualified annuity is taxed as ordinary income. But only the earned interest is taxed on distributions from a non-qualified annuity.

How estate taxes affect inherited annuities

The IRS imposes estate taxes on a person’s holdings when they die. Money from an inherited annuity may be subject to both income and estate tax. However, an exemption can prevent heirs from paying federal estate taxes on inherited annuities. In 2026, the federal estate tax exemption is $15 million per individual. Estates below these levels typically won’t owe federal estate tax. 

How payout schedules affect taxation

If you inherit an annuity, you may be offered a lump sum or periodic payments. If you choose the lump sum, the IRS will charge any applicable taxes within the same fiscal year. 

This could prove beneficial in the long run if you reinvest the money in a high-yield savings or tax-advantaged account. But the taxable income could push you into a higher tax bracket, increasing your immediate tax burden. 

If you select periodic distributions, you’ll be taxed on each installment. This means your immediate tax burden will be lower. 

What is the exclusion ratio and how does it work?

Exclusion ratios apply to non-qualified annuities. They separate each payment into two parts: 

• A tax-free portion representing your principal
• A taxable portion representing your earnings

For example, if you receive a payment of $1,300 — $1,000 in principal and $300 in interest — only the $300 is taxable. This method ensures you don’t pay income tax twice on the same amount of money.

How annuity withdrawals are taxed under the LIFO rule

If you take money out of a non-qualified annuity before converting it into periodic payments, the IRS will apply the Last In, First Out (LIFO) rule. This means the earnings come out first, before principal. Since the IRS taxes interest completely, you’ll be taxed at the ordinary income rate. Once all earnings have been withdrawn, the remaining balance becomes tax-free principal. 

Common tax mistakes to avoid with annuities

Two of the most common errors when projecting annuity taxes are misunderstanding tax treatment and not considering early withdrawal penalties. 

Having a tax-deferred annuity doesn’t eliminate taxes. Unless you have a Roth IRA, you’ll pay income tax on earnings when you withdraw money. 

Withdrawing money before the age of 59½ can trigger a 10% tax penalty from the IRS and possibly an additional fee from the annuity issuer. You may be able to avoid charges from the annuity issuer if you purchase a rider that permits early withdrawals during emergencies.

Common tax-reduction strategies for annuities

Reducing your annuity’s taxable income might sound complicated, but with some planning, you can keep more of your hard-earned money. Here are some practical tips to help you maximize your annuity while reducing your taxes:

• Leverage tax-free benefits: If you use a non-qualified annuity to grow your money with after-tax dollars, when you withdraw, you only pay taxes on the earnings — the original principal remains tax-free. It can also be beneficial to contribute to  qualified annuities to delay tax payments until you’re potentially in a lower tax bracket during retirement.
• Let your money grow tax-deferred: Most annuities provide tax-deferred growth, allowing your money to compound without incurring yearly taxes on any growth. And typically, annuities are taxed when distributed, meaning you only pay taxes as you receive payments. 

Talk to the experts: Tax rules can vary depending on the type of annuity you purchase, so it’s important to review the details or consult a financial professional or tax advisor before investing.

Save wisely with Gainbridge

Understanding how your savings will be taxed can help you project growth and future distributions. Before putting money away for retirement, consider the tax efficiency of any investment you’re considering. 

Explore Gainbridge and learn how modern qualified and non-qualified fixed annuities are structured. You can compare current guaranteed interest rates and see how our Traditional and Retirement annuity accounts can support predictable income goals.

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The Gainbridge® digital platform provides informational and educational resources intended only for self-directed purposes. Annuity (referred to as “Accounts”) products issued by Gainbridge Life Insurance Company (Zionsville, IN). Gainbridge Life Insurance Company “Gainbridge” is licensed and authorized to do business in 49 states (all states except New York) and the District of Columbia. Products and/or features may not be available in all states. The Save Retirement multi-year guaranteed annuity product with form number ICC22-D-MYGA-BASE, or variations of such and the Save Traditional™ multi-year guaranteed annuity product with form number ICC23-D-NTDMYGA-BASE, or variations of such are all issued by Gainbridge Life Insurance Company. Guarantees are based on the financial strength and claims paying ability of the issuing insurance company.

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Withdrawals of taxable amounts are subject to ordinary income tax and if made before age 59½, may be subject to a 10% federal income tax penalty. Distributions of taxable amounts from a nonqualified annuity may also be subject to an additional 3.8% federal tax on net investment income. Under current law, a nonqualified annuity that is owned by an individual is generally entitled to tax deferral. IRAs and qualified plans—such as 401(k)s and 403(b)s— are already tax-deferred. Therefore, a deferred annuity should only be used to fund an IRA or qualified plan to benefit from the annuity’s features other than tax deferral. These include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.

Because they are meant for long-term accumulation, most annuities have withdrawal charges that are assessed during the early years of the contract if the contract owner surrenders the annuity.

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