The tax treatment of an annuity depends on one question: was the money taxed before it went in? If you bought the annuity with pre-tax retirement dollars, every payment that comes out is taxable as ordinary income. If you bought it with after-tax savings, only the earnings are taxed. The rest of this guide explains exactly how that plays out in 2026, including the LIFO rule for withdrawals, the exclusion ratio for annuitized payments, the 10% early-withdrawal penalty, and the RMD rules that apply to qualified annuities. State tax rules vary, so we cover those at a high level only and point you to a local tax professional for the specifics.
This article is general education, not tax advice. Annuity taxation can change based on your age, state, contract type, and how the money moved in and out. Before you make any withdrawal, rollover, or annuitization decision, speak with a qualified tax professional who can review your exact contract and tax situation.
Qualified vs non-qualified annuities
A qualified annuity is funded with pre-tax money. That usually means a rollover from a 401(k), a traditional IRA, or another employer-sponsored retirement plan. Because you never paid tax on the principal or the growth, the IRS taxes every dollar that comes out as ordinary income in the year it is distributed. That is true whether you take a lump sum, a partial withdrawal, or a lifetime income stream.
A non-qualified annuity is funded with money you have already paid taxes on, such as savings from a bank account or a taxable brokerage account. Your original investment, called the cost basis, is not taxed again when it comes back to you. Only the earnings portion is taxed. The order in which principal and earnings are considered distributed is what makes the LIFO rule so important.
If you are comparing ways to move retirement money into an annuity, our guide on converting a 401(k) or IRA into an annuity walks through the rollover mechanics and the mistakes that trigger a taxable event.
The LIFO rule: earnings come out first
LIFO stands for last in, first out. For non-qualified annuities, the IRS treats withdrawals as coming from earnings before principal. That means the first dollars you withdraw are fully taxable until the cumulative withdrawals equal the total gain in the contract. Only after that point do withdrawals become a tax-free return of your original investment.
Here is a simple example. You put $100,000 into a non-qualified fixed annuity and it grows to $140,000. If you withdraw $20,000, the entire $20,000 is treated as taxable earnings because you still have $40,000 of gain remaining in the contract. If you later withdraw another $50,000, $40,000 of it is taxable and $10,000 is a return of principal. Once you have withdrawn the full $40,000 of gain, any additional withdrawals come back tax-free.
The LIFO rule is why it is usually a mistake to think of an annuity as a savings account where you can dip into principal whenever you want. The tax code does not see it that way until the earnings bucket is empty.
The exclusion ratio for annuitized payments
Annuitization changes the tax math. When you convert a non-qualified annuity into a stream of payments, the IRS uses an exclusion ratio to split each payment into two parts: a tax-free return of principal and a taxable portion representing earnings. The ratio is based on your investment in the contract divided by the total payments you are expected to receive over the payment period.
For a lifetime payout, the insurer uses life expectancy tables to estimate total expected payments. The portion of each payment that represents your cost basis is excluded from income tax. Once you have recovered your full cost basis, the entire payment becomes taxable. If you die before recovering your full principal, the unrecovered amount may be deductible on your final tax return, subject to limits and rules.
For qualified annuities, there is no exclusion ratio because the entire account was built with pre-tax money. Every payment is taxable as ordinary income. If you want to understand how the income election itself works, read annuitization explained.
The 10% early-withdrawal penalty
If you take a taxable distribution from an annuity before you turn 59 and a half, the IRS generally adds a 10% early-withdrawal penalty on the taxable portion. This applies to the earnings from a non-qualified annuity and to the full distribution from a qualified annuity. The penalty is in addition to ordinary income tax, not in place of it.
There are limited exceptions, such as distributions after the owner becomes disabled or after death, but most ordinary retirement withdrawals do not qualify. The penalty is separate from any surrender charges the insurance company charges, which means you can owe both the IRS penalty and the carrier fee in the same year.
Required minimum distributions on qualified annuities
Because qualified annuities hold pre-tax retirement money, they are subject to the same required minimum distribution rules as IRAs and 401(k)s. For 2026, the RMD starting age is 73 for most people who turned 72 after 2022. Once you reach that age, you must withdraw a minimum amount each year based on your life expectancy and account value. Failure to take the RMD triggers a steep penalty on the amount that should have been withdrawn.
Some annuity contracts are structured so that the income payments satisfy the RMD for that specific contract. That can be convenient, but it is not automatic. You still need to calculate RMDs across all your retirement accounts and make sure the combined withdrawals meet the IRS requirement. A tax professional can help you avoid double-paying or missing a deadline.
1035 exchanges and tax deferral
A 1035 exchange lets you swap one annuity for another without recognizing tax on the built-up gain. The tax bill stays deferred as long as the exchange is done directly between insurance companies and follows IRS rules. This is not a free pass to cash out. If the money passes through your hands, the exchange is broken and the gain becomes taxable.
We cover the exact mechanics in our guide to 1035 exchanges, including the contract types that qualify and the mistakes that turn a tax-free exchange into a taxable surrender.
State tax treatment
State taxation of annuity income varies widely. Some states do not tax income at all, some exempt a portion of retirement or pension income, and some tax annuity distributions at ordinary income rates. States may also treat qualified and non-qualified withdrawals differently. Because the rules change and can depend on your age, filing status, and total income, we do not publish specific state numbers here. The safest approach is to check your current state rules with a tax professional or your state revenue department before taking a distribution.
Tax treatment summary
| Situation | What is taxed | Special rule |
|---|---|---|
| Qualified annuity withdrawal | Full distribution as ordinary income | RMDs start at age 73; 10% penalty before 59½ |
| Non-qualified withdrawal | Earnings first under LIFO rule | 10% penalty on taxable portion before 59½ |
| Non-qualified annuitization | Exclusion ratio splits principal and earnings | Principal becomes taxable once fully recovered |
| Qualified annuitization | Full payment as ordinary income | RMDs still apply |
| 1035 exchange | No tax if done correctly | Must be direct between insurers |
Common mistakes to avoid
- Cashing out instead of rolling over. A direct rollover keeps the tax deferral intact. A check made out to you can trigger a taxable distribution and withholding.
- Withdrawing early without counting penalties. The 10% federal penalty plus surrender charges can eat up a large share of a premature withdrawal.
- Ignoring RMDs after annuitization. Some contracts satisfy RMDs through the income stream, but you must verify this across all your retirement accounts.
- Assuming annuity gains are capital gains. Annuity earnings are taxed as ordinary income, which is often a higher rate than long-term capital gains.
- Skipping state tax review. State rules on retirement income change frequently and can affect your net payout significantly.
Talk to a tax professional before you decide
Annuity tax rules are not something to guess at. The difference between a direct rollover and a cash-out, or between a partial withdrawal and annuitization, can cost thousands of dollars in taxes and penalties. A tax professional can review your contract, your current tax bracket, your state rules, and your retirement timeline to recommend the lowest-tax path for your specific situation.
If you would like to connect with a licensed annuity advisor who can explain your product options and tax implications together, contact Superb Assets and we will match you with someone in our network.