The Tax Advantage: Tax-Deferred Growth
The single biggest tax advantage of an annuity is tax-deferred growth. Unlike a bank CD, money market fund, or taxable brokerage account, the earnings inside an annuity are not taxed each year. Interest, dividends, and investment gains compound without an annual tax drag — and you owe nothing to the IRS until you make a withdrawal.
This matters because of compounding. In a taxable account, the IRS takes a cut of your earnings every year, which reduces the amount that compounds the following year. In an annuity, 100% of your earnings stay invested and continue growing. Over time, the difference is significant.
Taxable account (CD/bond fund): After paying 24% tax on interest each year, the effective annual growth rate is approximately 3.80%. After 20 years: ~$423,200.
Annuity (tax-deferred): The full 5% compounds each year. After 20 years the account value is ~$530,660. If fully surrendered and all gains taxed at 24%: after-tax value is ~$451,300.
Tax-deferral advantage: ~$28,100 more after taxes. And if you 1035 exchange to another annuity instead of cashing out, the deferral continues indefinitely.
When deferral helps most
- Higher tax brackets — The higher your marginal rate, the larger the annual tax drag on a taxable account. A saver in the 32% bracket benefits more from deferral than one in the 12% bracket.
- Longer time horizons — Compounding is exponential. The deferral advantage in year 5 is modest; by year 20, it becomes substantial.
- Higher interest rates — More earnings means more tax each year in a taxable account, and more tax saved by deferral.
- No need for current income — If you need the interest for living expenses, the deferral advantage is reduced because you will be withdrawing (and paying tax) anyway.
Tax-deferred growth is available in all annuity types: fixed, MYGA, FIA, variable, SPIA, and DIA. It applies to both qualified (IRA) and non-qualified annuities, though the tax mechanics at withdrawal differ substantially between the two, as explained in the next section.
Qualified vs. Non-Qualified Annuities
The most important distinction in annuity taxation is whether the contract is qualified or non-qualified. This single factor determines how every dollar coming out of the annuity is taxed.
An annuity purchased with pre-tax dollars inside a tax-advantaged retirement account such as a Traditional IRA, 401(k), 403(b), or SEP IRA. Because no income tax was paid on the contributions, the entire withdrawal — both principal and earnings — is taxed as ordinary income. Subject to Required Minimum Distributions (RMDs) starting at age 73. Annual contribution limits apply. The 10% early withdrawal penalty applies to the full withdrawal amount if taken before age 59½.
An annuity purchased with after-tax dollars — money on which you have already paid income tax. There is no annual contribution limit. Only the earnings portion is taxed upon withdrawal (as ordinary income); the return of your original premium is tax-free. Withdrawals follow the LIFO rule (earnings come out first). Not subject to RMDs during the owner’s lifetime. The 10% early withdrawal penalty applies only to the taxable (earnings) portion if taken before age 59½.
| Feature | Qualified Annuity | Non-Qualified Annuity |
|---|---|---|
| Funded with | Pre-tax dollars (IRA, 401(k), etc.) | After-tax dollars (personal savings) |
| Contribution limits | Yes — IRA/401(k) annual limits apply | No — invest any amount |
| Tax on earnings growth | Deferred | Deferred |
| Tax on withdrawals | 100% taxed as ordinary income | Only earnings taxed as ordinary income |
| Withdrawal order | Every dollar is taxable | LIFO — earnings come out first (taxable), then principal (tax-free) |
| 10% early penalty (before 59½) | On full withdrawal amount | On earnings portion only |
| Required Minimum Distributions | Yes — starting at age 73 | No — not during owner’s lifetime |
| 1035 exchange eligible | Yes (qualified to qualified only) | Yes (non-qualified to non-qualified only) |
| Death benefit taxation | Entire amount taxable to beneficiary | Only gains taxable to beneficiary |
| Step-up in basis at death | No | No |
Key takeaway: Qualified annuities give you a tax deduction going in but tax everything coming out. Non-qualified annuities give you no deduction going in but only tax the earnings coming out. Neither type receives a step-up in basis at death — this is a critical difference from stocks and real estate.
How Withdrawals Are Taxed
Non-qualified annuity withdrawals: The LIFO rule
For non-qualified annuities, the IRS requires that withdrawals follow the LIFO rule — Last In, First Out. This means that the most recent money “in” (i.e., the earnings that accumulated on top of your principal) is treated as coming “out” first. Since earnings have never been taxed, they are fully taxable as ordinary income when withdrawn.
Only after all earnings have been withdrawn do subsequent withdrawals become a tax-free return of your original premium (cost basis).
You withdraw $60,000.
• The first $42,000 is taxable (all earnings come out first under LIFO).
• The remaining $18,000 is tax-free return of premium.
• If you are in the 24% bracket, the tax on this withdrawal is $42,000 × 24% = $10,080.
After this withdrawal, $0 in earnings remains in the contract, and $132,000 of your original premium remains. All future withdrawals from this contract would be tax-free (until the contract earns additional interest).
Qualified annuity withdrawals: Every dollar is taxable
For qualified annuities (Traditional IRA, 401(k) rollover, etc.), the math is simpler — and the tax is larger. Because you received a tax deduction on your original contributions, the IRS has never taxed any of this money. Therefore, every dollar withdrawn is taxed as ordinary income, whether it represents original contributions or investment earnings.
The entire $60,000 is taxable as ordinary income.
• In the 24% bracket: $60,000 × 24% = $14,400 in tax.
Compare this to the non-qualified example above, where the same $60,000 withdrawal produced only $10,080 in tax. The qualified annuity withdrawal costs $4,320 more in taxes — because the original contributions were never taxed.
Roth IRA annuities: Tax-free withdrawals
Annuities held inside a Roth IRA offer the best tax treatment of all. Contributions were made with after-tax dollars (like non-qualified), but qualified withdrawals are entirely tax-free — including all earnings. To be qualified, you must be at least 59½ and the Roth IRA must have been open for at least 5 years. Roth IRAs are also exempt from RMDs during the owner’s lifetime.
The Exclusion Ratio
When you annuitize a non-qualified annuity — meaning you convert the lump-sum value into a stream of periodic payments (monthly, quarterly, or annually) — the tax treatment changes from LIFO to a more favorable method called the exclusion ratio.
Instead of all earnings coming out first (as with LIFO), each payment is split into two components: a taxable earnings portion and a tax-free return of your original premium. The exclusion ratio determines the split.
The percentage of each annuitized payment that is a tax-free return of premium. Calculated as:
Exclusion Ratio = Investment in the Contract ÷ Expected Return
The “investment in the contract” is your total after-tax premiums paid (cost basis). The “expected return” is the total amount you are expected to receive over the payout period (annual payment × life expectancy or certain period). The ratio remains fixed for the life of the payout.
Setup: You annuitize a non-qualified annuity with a $200,000 cost basis. The annuity value at annuitization is $320,000. The insurer offers a life-only payout of $24,000 per year. Your IRS life expectancy is 20 years (age 67).
Calculate expected return: $24,000/year × 20 years = $480,000.
Calculate exclusion ratio: $200,000 ÷ $480,000 = 41.67%.
Tax treatment of each $24,000 annual payment:
• Tax-free portion: $24,000 × 41.67% = $10,000 (return of premium).
• Taxable portion: $24,000 − $10,000 = $14,000 (ordinary income).
This ratio remains fixed for 20 years. After 20 years (once your full $200,000 cost basis has been recovered), each payment becomes 100% taxable. If you live longer than expected, you benefit from tax-free income during the exclusion period. The exclusion ratio makes annuitization more tax-efficient than lump-sum LIFO withdrawals for non-qualified contracts.
Key point: The exclusion ratio only applies to non-qualified annuities that are annuitized (converted to periodic payments). It does not apply to partial withdrawals, full surrenders, or qualified annuities. For qualified annuities, all annuitized payments are 100% taxable as ordinary income.
Master Tax Table: Every Scenario
The following table summarizes the tax treatment for every combination of transaction type and annuity qualification status. Bookmark this as a reference.
| Transaction | Non-Qualified | Qualified (Traditional IRA) | Roth IRA |
|---|---|---|---|
| Purchase (contributions) | After-tax dollars. No deduction. | Pre-tax dollars. Tax-deductible (subject to income limits). | After-tax dollars. No deduction. |
| Growth phase | Tax-deferred. No annual tax on earnings. | Tax-deferred. No annual tax on earnings. | Tax-free. No annual tax on earnings. |
| Partial withdrawal | LIFO: earnings come out first (taxed as ordinary income). After earnings exhausted, return of premium (tax-free). | 100% taxed as ordinary income. | Contributions first (tax-free). Then earnings: tax-free if qualified (59½ + 5-year rule). Taxable + penalty if not qualified. |
| Full surrender | Gain (value minus cost basis) taxed as ordinary income. Cost basis returned tax-free. | 100% taxed as ordinary income. | Tax-free if qualified. Earnings taxable + potential penalty if not qualified. |
| Annuitization | Exclusion ratio: each payment split into taxable earnings and tax-free return of premium. | 100% of each payment taxed as ordinary income. | Tax-free if qualified. |
| Death benefit — to spouse | Spouse can continue contract (spousal continuation). Taxes deferred until withdrawal. Only gains taxable. | Spouse can continue as own IRA or roll over. Taxes deferred until withdrawal. 100% taxable when withdrawn. | Spouse can continue as own Roth IRA. Tax-free withdrawals (if qualified). |
| Death benefit — to non-spouse | Gains taxed as ordinary income to beneficiary. No step-up in basis. Must distribute within timeframe (typically 5 years or life expectancy). | 100% taxed as ordinary income to beneficiary. No step-up in basis. Must distribute within 10 years (SECURE Act). | Tax-free if original owner met 5-year rule. Must distribute within 10 years (SECURE Act). No step-up needed (already tax-free). |
| 1035 exchange | Tax-free transfer to another non-qualified annuity. Cost basis carries over. Cannot cross to qualified. | Tax-free transfer to another qualified annuity or IRA. Cannot cross to non-qualified. | Tax-free transfer to another Roth IRA annuity. |
Tax Treatment by Annuity Type
The core tax rules (deferred growth, LIFO, exclusion ratio) apply to all annuity types. However, some annuity types have unique tax considerations worth noting.
| Annuity Type | Tax Treatment | Special Tax Notes |
|---|---|---|
| Fixed / MYGA | Standard. Interest grows tax-deferred. Withdrawals taxed per LIFO (NQ) or fully (qualified). | Simplest tax situation. Interest credited annually is not taxable until withdrawn. At MYGA maturity, no tax is due unless you take a distribution — you can 1035 exchange to a new contract tax-free. |
| Fixed Indexed (FIA) | Standard. Index-linked credits grow tax-deferred. Withdrawals follow normal rules. | Index credits are treated as ordinary interest for tax purposes — never as capital gains, even though they are linked to a stock index. Participation rate changes and cap adjustments do not create taxable events. |
| Variable Annuity | Standard tax-deferred treatment. Sub-account gains/losses are not taxable until withdrawal. | Sub-account gains are taxed as ordinary income at withdrawal, not as capital gains. This is a disadvantage compared to holding the same funds in a taxable brokerage account where they could qualify for lower long-term capital gains rates. High internal fees (1.5–3%+) compound the tax inefficiency. |
| SPIA (Immediate Annuity) | Non-qualified: each payment uses exclusion ratio. Qualified: each payment is fully taxable. | Because SPIAs begin payments immediately, the exclusion ratio applies from the first payment. The tax-free portion of each payment remains constant for the payout period. After cost basis is fully recovered, payments become 100% taxable. |
| DIA (Deferred Income Annuity) | Same as SPIA but deferral period adds additional tax-deferred growth before payments begin. | During the deferral period, growth is tax-deferred. When payments begin, the exclusion ratio is more favorable than a SPIA because the longer deferral means a higher expected return in the denominator, increasing the tax-free portion of each payment. |
| QLAC (Qualified Longevity Annuity Contract) | Payments are 100% taxable as ordinary income (qualified money only). | Unique RMD advantage: Up to $200,000 (indexed, as of 2024) of qualified retirement assets can be placed in a QLAC and excluded from RMD calculations until payments begin (as late as age 85). This can significantly reduce RMDs and associated taxes between ages 73 and 85. |
The 10% Early Withdrawal Penalty
If you withdraw money from an annuity before age 59½, the IRS imposes a 10% early withdrawal penalty on the taxable portion of the withdrawal — in addition to the regular ordinary income tax you already owe.
This penalty is separate from any surrender charges the insurance company may impose. You can owe both: the insurer’s surrender charge AND the IRS’s 10% penalty.
How the penalty applies
| Annuity Type | Penalty Base | Example: $50,000 Withdrawal with $30,000 in Gains |
|---|---|---|
| Non-qualified | Earnings portion only | $30,000 in gains comes out first (LIFO). 10% penalty on $30,000 = $3,000 penalty. Plus ordinary income tax on $30,000. |
| Qualified (Traditional IRA) | Entire withdrawal | Full $50,000 is taxable. 10% penalty on $50,000 = $5,000 penalty. Plus ordinary income tax on $50,000. |
| Roth IRA | Earnings portion only (if not a qualified distribution) | Contributions come out first tax-free ($20,000). Remaining $30,000 is earnings. 10% penalty on $30,000 = $3,000 penalty. Plus ordinary income tax on $30,000. |
Exceptions to the 10% penalty
The IRS provides several exceptions where early withdrawals avoid the 10% penalty (though ordinary income tax still applies):
- Death — Distributions to beneficiaries after the owner’s death are exempt from the penalty.
- Disability — If the owner becomes totally and permanently disabled as defined by the IRS.
- Substantially Equal Periodic Payments (SEPP / 72(t)) — A series of substantially equal payments based on life expectancy. Must continue for 5 years or until age 59½ (whichever is longer). Breaking the schedule retroactively applies the penalty to all prior payments.
- Immediate annuities (SPIA) — Payments from an immediate annuity that has been annuitized are generally treated as meeting the SEPP requirements, avoiding the penalty even before 59½.
Death and Estate Taxes
What happens to annuity taxes when the owner dies depends on who inherits the contract: a surviving spouse or a non-spouse beneficiary.
Surviving spouse options
A surviving spouse has the most flexibility. They can:
- Spousal continuation: Become the new owner of the contract and continue tax-deferred growth. No taxes are due. Withdrawals are taxed normally when eventually taken. This is usually the best option if the spouse does not need the money immediately.
- Lump-sum distribution: Cash out the entire contract. All gains are taxed as ordinary income in the year received (which may push the spouse into a higher bracket).
- Annuitize: Convert to periodic payments. Non-qualified contracts use the exclusion ratio. Qualified contracts are fully taxable.
Non-spouse beneficiary options
Non-spouse beneficiaries have fewer options and shorter timelines:
- Lump-sum distribution: Cash out and pay all taxes immediately. Simple but potentially expensive if the gains are large.
- 5-year rule (non-qualified): Distribute the entire death benefit within 5 years of the owner’s death. Allows spreading the tax impact across multiple years.
- 10-year rule (qualified, SECURE Act): Most non-spouse beneficiaries must fully distribute inherited qualified annuities within 10 years of the owner’s death. Stretch IRA provisions were largely eliminated by the SECURE Act of 2019.
- Life expectancy method (limited): Only available to certain “eligible designated beneficiaries” — minor children, disabled individuals, chronically ill individuals, and beneficiaries not more than 10 years younger than the deceased.
Estate taxes
The death benefit is included in the deceased’s estate for estate tax purposes. For 2026, the federal estate tax exemption is scheduled to decrease (consult current tax law for the applicable threshold). Most estates do not owe federal estate tax, but the annuity’s value counts toward the threshold. State estate taxes, where applicable, may have lower exemption amounts.
In cases where both income tax (to the beneficiary) and estate tax (on the estate) apply to the same annuity death benefit, the beneficiary may be eligible for an income tax deduction for estate taxes paid on the annuity, known as the IRD (Income in Respect of a Decedent) deduction. This prevents full double taxation but does not eliminate it entirely.
1035 Exchanges: Tax-Free Transfers
A 1035 exchange (named after IRC Section 1035) allows you to transfer one annuity to another without triggering any taxable event. Your cost basis carries over, all deferred gains remain deferred, and no taxes are due at the time of transfer.
This is one of the most powerful tax planning tools available to annuity owners. You can:
- Move from a high-fee variable annuity to a no-fee MYGA or FIA — tax-free
- Exchange a maturing MYGA into a new contract at a higher rate — tax-free
- Convert an accumulation annuity into an income annuity (SPIA or DIA) — tax-free
- Switch carriers for better financial strength — tax-free
- Do a partial 1035 exchange (transferring a portion of the contract) — tax-free
The key rules: funds must transfer directly between insurance companies (you must never receive a check), the owner and annuitant must remain the same, and you cannot cross between qualified and non-qualified status.
Tax Planning Strategies
Choosing qualified vs. non-qualified
- Use qualified (IRA) annuities when: You want the upfront tax deduction and plan to withdraw in retirement when your tax bracket may be lower. Best for Traditional IRA rollovers and 401(k) consolidation. Remember: RMDs apply starting at age 73.
- Use non-qualified annuities when: You have already maximized IRA/401(k) contributions and want additional tax-deferred growth with no contribution limits. The LIFO rule means earnings are taxed first on withdrawals, but the exclusion ratio at annuitization is more favorable. No RMDs during your lifetime.
- Consider Roth IRA annuities when: You expect to be in the same or higher tax bracket in retirement, want tax-free income, and want to avoid RMDs. Best for younger savers or those doing Roth conversions.
Timing withdrawals to minimize brackets
Because annuity withdrawals are taxed as ordinary income, the timing of withdrawals directly affects your tax rate. Strategies include:
- Gap years: If you have years with lower income (between retirement and Social Security, for example), take annuity withdrawals during those low-bracket years to fill up the lower tax brackets.
- Spread large distributions: Instead of a lump-sum surrender (which could push you into the 32%+ bracket), spread withdrawals across multiple tax years to stay in lower brackets.
- Coordinate with Social Security: Up to 85% of Social Security benefits become taxable as your income rises. A large annuity withdrawal can trigger additional taxation of your Social Security benefits — effectively creating a hidden marginal rate increase. Time withdrawals to minimize this interaction.
Coordinating with RMDs
For qualified annuities, RMDs begin at age 73. Strategies to manage RMD taxation include:
- QLAC allocation: Place up to $200,000 (indexed) of qualified assets in a Qualified Longevity Annuity Contract to exclude that amount from RMD calculations until payments begin (as late as age 85). This reduces annual RMDs and the associated tax liability.
- Annuitize before RMD age: If you plan to annuitize a qualified annuity, doing so before RMDs begin gives you more control over payment timing and structure.
- Roth conversions: In the years before RMDs begin, consider converting qualified annuity funds to Roth (paying tax now at potentially lower rates) to reduce future RMD-driven taxation.
Using 1035 exchanges strategically
- Fee reduction: Exchange high-fee variable annuities to low-cost or no-fee products. The fee savings compound tax-deferred, amplifying the benefit.
- Continuous deferral: At MYGA maturity, 1035 exchange to a new MYGA rather than surrendering. This avoids triggering tax on accumulated gains and restarts the deferral period.
- Income transition: Exchange an accumulation annuity to an income annuity (SPIA or DIA) tax-free, enabling the more favorable exclusion ratio treatment at annuitization.
Estate planning considerations
- Name a spouse as beneficiary to enable spousal continuation and maximum tax deferral.
- Consider whether annuities are the right asset to leave to heirs. Because annuities do not receive a step-up in basis, other assets (stocks, real estate) may be more tax-efficient for inheritance. Some planners recommend spending down annuities during your lifetime and leaving step-up-eligible assets to heirs.
- Life insurance offset: If leaving an annuity to non-spouse heirs is unavoidable, a life insurance policy can help offset the income tax the beneficiary will owe on the inherited annuity gains.