Annuities receive favorable tax treatment compared to most other savings vehicles — but the rules vary depending on whether your annuity is inside a qualified retirement account (like an IRA) or purchased with after-tax money (non-qualified). Understanding the difference can significantly affect your retirement income planning.
Non-Qualified Annuities (Purchased with After-Tax Money)
When you buy an annuity with money you’ve already paid taxes on, your principal is not taxed again on withdrawal. Only the earnings are taxable. Each payment contains a tax-free portion (return of principal) and a taxable portion (earnings), calculated using the “exclusion ratio.”
Qualified Annuities (Inside an IRA or 401(k) Rollover)
If your annuity is held inside an IRA or funded with pre-tax rollover money, all withdrawals are taxed as ordinary income — including both principal and earnings. Required Minimum Distributions (RMDs) also apply starting at age 73.
Tax-Deferred Growth
Whether qualified or non-qualified, annuity earnings grow tax-deferred inside the contract. You owe no taxes on credited interest each year — only upon withdrawal. Over 10–20 years, this compounding advantage can be substantial compared to a taxable savings account.
Early Withdrawal Penalty
Withdrawals before age 59½ are subject to a 10% IRS early withdrawal penalty on the taxable portion, on top of ordinary income tax. Most contracts also impose their own surrender charges for early withdrawals during the surrender period.
Last-In, First-Out (LIFO) Rule
For non-qualified annuities, the IRS treats withdrawals as coming from earnings first — meaning you pay tax on your gains before receiving your tax-free principal back. This applies to partial withdrawals, not annuitized income streams.
Inherited Annuities
Beneficiaries who inherit a non-qualified annuity pay income tax on the earnings portion of any distributions. Non-spouse beneficiaries generally must distribute the full contract value within 10 years under current IRS rules.
Call us at 1-888-972-0024 to discuss how an annuity fits into your overall tax and retirement strategy.