How Are Annuities Taxed? What to Know Before You Withdraw

Annuities are powerful financial tools for retirement, offering guaranteed income and long-term growth potential. But before you start tapping into your annuity, it’s critical to understand how annuities are taxed—because withdrawals can carry unexpected tax consequences if you’re not prepared. Here’s what you need to know.

1. Qualified vs. Non-Qualified Annuities

Taxation on annuities primarily depends on how they were funded:

• Qualified Annuities are funded with pre-tax dollars, typically within an IRA or 401(k). Since you haven’t paid taxes on this money yet, all withdrawals will be taxed as ordinary income.

• Non-Qualified Annuities are funded with after-tax dollars. In this case, only the earnings portion of your withdrawal is taxed; your original contributions are not.

2. Taxation Follows the “Last In, First Out” (LIFO) Rule

With non-qualified annuities, the IRS uses the LIFO method—meaning your earnings are withdrawn first and taxed as ordinary income. Only after all earnings are withdrawn can you begin taking out your tax-free principal.

Example:

Let’s say you invested $100,000 and your annuity grew to $150,000. The first $50,000 you withdraw is taxable as income. After that, your original $100,000 is tax-free.

3. Watch Out for Early Withdrawal Penalties

If you withdraw funds before age 59½, the IRS may hit you with a 10% early withdrawal penalty on the taxable portion—on top of ordinary income tax. This is similar to early withdrawals from other retirement accounts.

4. Annuitized Payments Are Taxed Differently

Once you convert your annuity into a stream of regular payments (annuitization), each payment is typically split into:

• A taxable portion (your earnings)

• A non-taxable portion (your principal)

The insurer uses something called an exclusion ratio to determine how much of each payment is taxable.

5. Inherited Annuities Are Also Taxable

If you inherit an annuity, taxes still apply. Beneficiaries usually pay ordinary income tax on the earnings portion. The exact tax treatment depends on the type of annuity and the relationship between the original owner and the beneficiary.

6. State Taxes May Also Apply

In addition to federal taxes, some states tax annuity income—so don’t forget to check local tax laws or consult with a tax advisor.

Final Thoughts: Plan Before You Withdraw

Taxes can significantly reduce the value of your annuity if you're not careful. To avoid surprises:

✅ Understand whether your annuity is qualified or non-qualified✅ Time your withdrawals to avoid penalties✅ Work with a tax or financial professional to create a withdrawal strategy

At Avalon Tax & Financial Services, we help clients make tax-smart retirement decisions—so their money goes further, longer. Schedule a consultation today to review your annuity and withdrawal plan with a licensed advisor.