Tax-deferred growth, the LIFO rule, qualified vs. non-qualified money — it sounds complex, but the core ideas are simple. Here's a plain-English guide to how annuities are taxed.
Annuity taxation sounds complicated, but the core idea is simple: your money grows tax-deferred. That means you don't pay taxes on the growth as it accumulates — only when you take the money out. How it's taxed at withdrawal depends mostly on one thing: whether you used pre-tax or already-taxed money to fund it.
This page is general education, not tax advice. Tax rules are individual and they change. Always confirm your specific situation with a qualified tax professional before acting. Devin is not a tax advisor.
This is the distinction that shapes everything else — and it comes down to one question: had your deposit already been taxed before it went in?
For non-qualified annuities, the IRS uses a "Last-In, First-Out" (LIFO) rule. In plain terms: when you take a withdrawal, the growth is treated as coming out first (and is taxable), and only after all the growth is withdrawn do you start getting your original, tax-free deposit back.
This catches people off guard, so it's worth knowing before you take a partial withdrawal.
As with most retirement vehicles, withdrawing taxable amounts before age 59½ may trigger an extra 10% federal penalty on top of income tax, unless an exception applies. Annuities are generally meant as longer-term vehicles for this reason.
Turning it into income (annuitization). If you convert a non-qualified annuity into a stream of income payments, each payment is split into a taxable part (growth) and a tax-free part (your returned deposit), spread across your life expectancy using what's called an "exclusion ratio." This can spread the tax impact more evenly than lump-sum withdrawals.
What happens at death. Most fixed annuities pass directly to your named beneficiary, usually avoiding probate. A beneficiary generally owes ordinary income tax only on the amount above your original deposit. A surviving spouse can often continue the contract as their own, preserving the tax deferral.
Own an annuity that's out of surrender and outclassed by today's options? Section 1035 of the tax code lets you move to a new contract without triggering taxes on the gain — but only if it's done the right way. The rule is simple: the money must travel directly between insurance companies. Touch it yourself, even briefly, and the IRS can treat the entire gain as a taxable withdrawal.
A 1035 isn't automatically smart. Surrender charges or features you'd give up can outweigh a better rate. A proper review puts old and new side by side, in writing — and sometimes concludes you should stay exactly where you are. That's a good outcome too. If your annuity is nearing the end of its surrender period, the Maturity Center covers when an exchange makes sense.
No pressure, no obligation. Explore the rate tool, take the 2-minute quiz, or ask Devin anything — whatever helps you understand your options.