Whether my annuity earnings are taxable depends on how the annuity was funded and when money comes out. In general, annuity growth is tax-deferred, so taxes usually become due when you receive a distribution. Payments from a qualified annuity funded with pre-tax dollars are generally fully taxable, while payments from a nonqualified annuity can include both tax-free returned principal and taxable earnings.
It’s understandable to feel unsure when the rules vary by annuity type and how you take money out. The key is to distinguish the original contributions from the annuity’s growth, then understand how each is treated when distributed.
This article explains how qualified and nonqualified annuities are taxed, how withdrawals and regular payments may be treated, and which tax details can affect retirement income. You’ll get a clearer picture of what to expect and why the same annuity can be taxed differently depending on its funding and payout method.
Key Takeaways
- Whether an annuity payment is taxable depends on how it was funded and whether the money is a contribution or earnings.
- Qualified and nonqualified annuities follow different tax rules, so identifying the account type helps clarify what may be taxable.
- Withholding from a payment can affect the amount you receive, but it does not by itself determine your final tax bill.
- Before taking money out, consider how the withdrawal method and your age may affect taxes and potential penalties.
- Understanding how tax-deferred growth works can help you make more informed choices about annuity income.
Table of Contents
When do you pay taxes on annuities?
In 2026, the key tax question is when money leaves the annuity, and how it was funded. A qualified annuity sits inside a tax-favored retirement account, such as an IRA or employer plan. Its qualified status doesn’t make withdrawals tax-free. It means the account’s tax rules apply to the money invested and distributed.
When a qualified annuity is funded with pre-tax or tax-deductible dollars, distributions are generally 100% taxable as ordinary income. That includes withdrawals and regular annuity payments. The taxable amount is generally included in the recipient’s income for the year it is received. Annuity growth can accumulate tax-deferred before distribution, but that timing doesn’t erase the tax due when taxable funds come out.
Holding an annuity inside an IRA or employer plan doesn’t provide an extra tax benefit beyond the underlying retirement plan. The account already determines how contributions and withdrawals are treated. For example, putting an annuity inside a traditional IRA doesn’t add a second layer of tax deferral. Any contribution deduction depends on the rules for the underlying account.
Qualified and nonqualified annuities differ mainly in how they’re funded and taxed. A nonqualified annuity is purchased with money that has already been taxed. Its original principal generally comes back tax-free, while earnings are taxed as ordinary income when distributed. For annuitized nonqualified payments, the exclusion ratio divides each payment into a taxable earnings portion and a tax-free return of principal.
For example, a nonqualified annuity with a $90,000 basis and a $120,000 contract value has a 75% exclusion ratio. That percentage helps allocate annuitized payments between taxable earnings and returned principal. It does not mean every withdrawal follows the same allocation method, because the payout method matters. The difference is useful when comparing regular payments with a lump-sum withdrawal.
Timing can matter for qualified annuity funds, too. An early withdrawal from a pretax qualified annuity may expose the entire distribution to the IRS early-withdrawal penalty, in addition to income tax. Required minimum distributions from most qualified accounts must generally start at age 73 under current rules. So, the account type, source of contributions, and distribution timing all shape when taxes apply and how much of a payment is taxable.
Is my pension or annuity payment taxable?
In 2026, tax depends on the payment’s source, its tax-free portion, and withholding. Federal and state rules can affect different parts of the same retirement payment.
Federal income tax withholding
Federal withholding is money taken from a payment and sent toward your income tax. It affects how much you receive now, but it isn’t the same as calculating your final tax bill.
For an eligible rollover distribution from a qualified retirement plan paid to you, the Internal Revenue Service says payers must withhold 20% of the taxable amount. That rule concerns eligible rollover distributions, not every pension or annuity payment. The distinction matters: identify the payment type and taxable portion before estimating the money you’ll receive.
Tax-deferred growth and ordinary income tax
Tax-deferred growth means annuity earnings can accumulate without current income tax on that growth. When taxable funds are paid out, earnings are generally taxed as ordinary income, not at capital-gains rates.
Tax deferral changes when tax is due, not how taxable earnings are classified. Growth left in a deferred annuity stays inside the contract. Once distributed, its taxable portion can add to income for that tax year. This distinction explains why a payment may be partly taxable rather than entirely tax-free.
Taxation of withdrawals and annuity income
A withdrawal and a scheduled annuity payment can have different taxable portions. For a nonqualified annuity, annuitized payments are divided between taxable earnings and tax-free basis under the exclusion ratio. A pension payment may also include a tax-free return of after-tax contributions.
If the recipient has no investment remaining in the contract, pension or annuity payments are fully taxable, including when prior after-tax contributions were already received tax-free. For payments starting after November 18, 1996, taxpayers generally use the simplified method to calculate taxable and tax-free portions. The payment start date and contribution history therefore matter.
State taxes on annuity income
State income tax treatment can change how much retirement income remains after federal taxes. Washington’s capital gains tax does not apply to annuity distributions. Iowa began phasing out state income tax on retirement income in 2023 for taxpayers age 55 and older.
Pennsylvania exempts qualified retirement distributions for taxpayers age 59½ or older. These examples show why the state where you file and the payment type matter. Don’t assume a state rule for one kind of retirement income applies to every annuity payment.
A payer typically sends Form 1099-R each year to report a distribution’s taxable portion to the IRS. Compare that form with your payment records and account details. The taxable amount, any tax-free return of contributions, and federal withholding each affect how the payment appears in your income-tax picture.
Tax treatment of nonqualified annuities
Under the last-in, first-out rule, earnings come out before your original contributions. As a result, withdrawals from a nonqualified annuity are taxable until the contract’s earnings have been distributed.
A nonqualified annuity is generally funded with after-tax money. Contributions form the contract’s basis, while growth represents earnings. Before annuitization, withdrawals are usually taxed earnings-first, rather than divided proportionally between principal and growth. Annuitized payments differ: the exclusion ratio divides them into taxable earnings and tax-free basis. The way you take distributions affects which portion is taxable.
Consider a nonqualified annuity worth $130,000, including $30,000 in earnings. If the owner takes a $20,000 withdrawal before annuitization, the full withdrawal is taxable under the earnings-first rule. This example shows why a withdrawal may be fully taxable even when the contract also contains after-tax contributions.
Age can affect the cost of an early withdrawal. According to the Internal Revenue Service, an annuity owner younger than 59½ who withdraws funds may owe a 10 percent tax penalty on the taxable portion. For a nonqualified annuity, typically only withdrawn earnings face this additional penalty. That penalty is separate from ordinary income tax on the taxable amount, so an early distribution can have more than one tax consequence.
Nonqualified annuities are usually funded with after-tax money, while qualified retirement accounts commonly use pretax dollars. If an annuity is held within a qualified plan, the plan’s tax treatment applies. Distributions funded with pretax or tax-deductible dollars are generally fully taxable as ordinary income. Calling a contract an annuity doesn’t change the tax treatment set by its account and funding source.
Before taking money out, identify whether the contract is qualified or nonqualified and whether it has been annuitized. Then compare the withdrawal amount with the contract’s earnings and contribution basis. For instance, the $20,000 withdrawal in the example is treated differently from a payment calculated under an exclusion ratio. These details help clarify the taxable amount and any possible early-withdrawal penalty before money leaves the contract.
Tax-deferred annuity growth
In 2026, tax deferral means earnings inside an annuity generally aren’t taxed each year as they accumulate. Instead, taxes generally become due when money is distributed. The distinction is about timing, not permanent tax exemption: growth can remain in the contract during accumulation, then become part of the taxable amount when paid out.
A deferred annuity has an accumulation period followed by a payout period. During accumulation, earnings stay in the contract rather than being received as current income. This lets the contract grow without annual income tax on its internal earnings. The tax question changes when you take money out: the distribution’s taxable portion is then reported as income under the rules for that annuity and its funding.
Think of the contract in two stages. First, contributions and any growth remain invested during deferral. Later, a withdrawal or annuity payment moves money out, making the taxable portion relevant for that tax year. This explains why a statement showing growth doesn’t necessarily mean you owe current income tax on that growth while it remains in the annuity.
Tax treatment also depends on where the contract’s funds came from. With a nonqualified annuity funded by after-tax money, the original principal is generally returned tax-free, while growth is taxed as ordinary income when distributed. A qualified annuity held in an IRA or employer plan follows the underlying plan’s tax treatment. Putting an annuity inside the plan doesn’t add a separate layer of tax deferral.
For retirement income planning, distinguish the original contributions, earnings, and amount distributed. Leaving earnings in a deferred contract is different from taking a withdrawal that includes them. If the contract pays regular income, the taxable portion depends on the funding and payout rules. This helps explain why a distribution may be partly taxable rather than matching the full contract value.
With tax deferral, the timing of income matters. A distribution adds its taxable portion to income for the year received, while undistributed growth remains inside the contract. Earnings are generally taxed as ordinary income when distributed, not at capital-gains rates, regardless of how long the annuity was held. So track not just how much the contract has grown, but whether and how money has come out.

Whether annuity earnings are taxable
You may be asking, “Are my annuity earnings taxable?” Generally, earnings become taxable when distributed, not simply because the contract’s value grows. The distinction is between earnings and original contributions. Distributed earnings are generally taxed as ordinary income, while after-tax contributions may be returned tax-free under the contract’s distribution rules. The answer depends on what a payment contains and how the annuity was funded.
The time an annuity is held doesn’t turn its earnings into capital gains. Growth distributed after many years is generally still treated as ordinary income. This matters when estimating taxable income for the year: the contract’s total value isn’t necessarily the amount included. Focus on the distribution and its taxable portion, rather than treating all accumulated growth as immediately taxable.
A qualifying 1035 exchange can transfer an existing annuity directly to a new annuity without treating the transfer as a taxable withdrawal at that time. This matters when considering a contract change. A direct qualifying exchange differs from taking the money personally and then reinvesting it. The exchange rule applies to the transfer itself; it doesn’t make later distributions tax-free.
Taxable annuity income also counts when determining whether any Social Security benefits are taxable. A distribution could therefore affect more than the income reported from the annuity alone. Roth accounts follow a separate rule: the Internal Revenue Service says withdrawals are tax-free when the money has been in the account for at least five years and the owner is at least 59½ at distribution, or meets another qualifying event such as death or disability.
Inheritance changes who receives an annuity, but it doesn’t erase the original tax basis. Annuities don’t receive a step-up in basis when the owner dies, so beneficiaries inherit the original cost basis. Under the five-year distribution option, the Internal Revenue Service requires the beneficiary to withdraw all funds by the end of five years. Payment timing and taxable earnings still matter.
To assess whether your annuity earnings are taxable, distinguish original contributions from earnings, then identify the account type and payout method. Keep the contract statement and distribution tax form together. A tax professional can use them to assess the taxable portion and related income considerations. These records can also help you evaluate how a proposed distribution fits your retirement income plans.
The Modern Medicare Agency: Medicare Advantage Plans
The Modern Medicare Agency helps people compare Medicare Advantage Plans and understand how Medicare coverage fits their retirement needs. Annuity tax rules explain how retirement income is treated, while Medicare plan choices address a separate part of retirement planning.
If you’re reviewing coverage alongside income decisions, The Modern Medicare Agency can also help you compare Medicare Supplement (Medigap) Plans and Medicare Part D Plans. Its independent guidance can make those insurance choices easier to understand, without confusing them with tax advice about an annuity.
For help comparing Medicare coverage, contact The Modern Medicare Agency or visit paulbinsurance.com.
Make your next retirement decision with clarity
Knowing whether your annuity earnings are taxable is one part of planning how retirement income fits your wider priorities. Gather your contract details and payment records, then consider how upcoming income choices fit your household budget and coverage needs. A tax professional can help explain the tax treatment of your specific situation.
Insurance decisions are separate from annuity tax advice, but both can affect how prepared you feel for retirement. The Modern Medicare Agency can help you explore coverage choices with clear, personalized guidance, so you can focus on the options that matter to you.
When you’re ready to discuss Medicare coverage, contact The Modern Medicare Agency. Take the next step at your own pace, with a clearer understanding of the decisions ahead.
Frequently Asked Questions
How Is an Annuity Taxed?
Annuity tax treatment depends on the account and the money used to fund it. A qualified annuity funded with pre-tax dollars generally produces taxable distributions. With a nonqualified contract, after-tax contributions and earnings may be treated differently. For example, a lump-sum withdrawal may be taxed differently from scheduled payments. Identify the account type and payout method first, then review the taxable amount shown on your distribution statement.
Are Annuities Tax-Efficient?
Annuities can defer income tax on growth until money is distributed, which may suit someone who doesn’t need immediate access to those earnings. But tax deferral isn’t tax exemption. Distributions can increase taxable income, and early withdrawals may trigger an additional tax penalty. Whether the timing benefit fits depends on when you expect to take income and how the annuity is funded.
Do annuities get a step-up in basis at death?
No. Annuities don’t receive a step-up in basis when the owner dies, so a beneficiary generally inherits the original cost basis. The contract’s earnings don’t become tax-free simply through inheritance. For example, a beneficiary receiving payments may need to distinguish the inherited basis from taxable earnings. The distribution option and the annuity’s tax status also affect when those amounts are reported.
Do you have to report annuity payments on your tax return?
Generally, report the taxable portion of annuity payments as income on your federal tax return. An annuity company typically sends Form 1099-R each year to report a distribution’s taxable portion to the IRS. Compare the form with your payment records, especially if a payment includes returned after-tax contributions. Withholding shown on the form is a tax payment already made, not a determination of your final tax owed.
Are earnings in a deferred annuity taxable before withdrawal?
Generally, deferred annuity earnings aren’t taxed each year while they remain in the contract. Tax is generally due when funds are distributed. A contract statement may show accumulated growth even if you haven’t taken money out. The tax result changes when you receive a withdrawal or begin payments. The taxable amount then depends on whether the annuity is qualified or nonqualified and how it was funded.
How are annuity withdrawals taxed in the United States?
In the United States, withdrawal taxation depends on whether the annuity is qualified, nonqualified, or held in a Roth account. For nonqualified withdrawals taken before annuitization, earnings are generally treated as coming out first, making a withdrawal taxable until earnings are distributed. The Internal Revenue Service says an owner younger than 59½ may owe a 10 percent penalty on the taxable portion. Account type and age both matter.
Are annuity earnings taxed as ordinary income or capital gains?
Annuity earnings are generally taxed as ordinary income when distributed, rather than at capital-gains rates. The holding period doesn’t change that treatment. Earnings distributed after an annuity has been held for many years don’t become capital gains simply because time has passed. This is separate from determining whether a particular payment also includes a tax-free return of the owner’s after-tax contributions.
How are earnings and principal taxed when annuity payments begin?
For a nonqualified annuity converted to regular payments, each payment is divided between taxable earnings and a tax-free return of principal using the exclusion ratio. That differs from a withdrawal before annuitization, where earnings generally come out first. If an annuity has no remaining investment in the contract, payments are fully taxable. The funding history and payment structure help determine how each payment is treated.
Article by
Paul Barrett
Paul Barrett, CMIP is the founder of The Modern Medicare Agency, an independent Medicare-only brokerage based in Melville, NY. With 18 years of Medicare-exclusive experience, a CMIP designation, and more than 5,000 clients served across 37 states, Paul is one of the most credentialed independent Medicare specialists on Long Island — and one of the most direct.
He represents 40+ carriers with no quotas and no allegiances, which means his recommendations are based entirely on what fits each client's specific situation. He is the author of Medicare Mastery Unlocked and host of the Wise Guys Retirement Talk podcast. His content is grounded in primary sources, real carrier intelligence, and 18 years of watching what happens when people get Medicare right — and when they don't.
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