Are Annuity Payments Taxable? A Practical Guide to Understanding How Your Income Will Be Taxed

Are Annuity Payments Taxable?

A Clear Guide for Retirement-Focused Investors

For anyone planning future income, annuities can be a reliable tool. But before incorporating them into a long-term strategy, it’s important to understand how the payments you receive will be taxed. The answer depends largely on how the annuity was funded and how distributions are taken.

Below is a straightforward breakdown to help you make informed decisions as you plan out the next phase of your financial life.

How Annuity Taxation Works

At the most basic level, annuity taxation follows a simple principle:

You pay taxes on the portion of the annuity payment that represents earnings, not on the portion that represents a return of your original investment.

However, the taxes you owe, and when you owe them, depend on whether your annuity is qualified or non-qualified.

Qualified Annuities: Fully Taxable at Withdrawal

A qualified annuity is funded with pre-tax dollars, typically inside a retirement account such as:

• Traditional IRA

• 401(k) rollover

• Other tax-deferred employer plans

Because contributions were made with pre-tax money, the IRS has not yet collected any tax on those dollars. That means:

100% of your annuity payments are taxable as ordinary income upon withdrawal.

This includes both your original principal and the earnings. Just like any other qualified account.

Non-Qualified Annuities: Only Earnings Are Taxable

A non-qualified annuity is funded with after-tax dollars, meaning you already paid tax on the money you contributed.

As a result:

• The portion representing your original premium is not taxed again.

• The portion representing investment growth is taxable as ordinary income.

When paid out as lifetime income, the IRS generally uses an exclusion ratio to determine how much of each payment is taxable vs. tax-free.

Lump-Sum Withdrawals and Taxation

Taking withdrawals before annuitizing (turning the contract into scheduled income payments) works differently:

• Withdrawals are taxed LIFO (last in, first out).

• Earnings come out first and are fully taxable.

• Principal comes out after earnings have been withdrawn.

For some investors, this creates unnecessary tax drag, which is why structured income payments, when appropriate, can offer more predictable taxation.

What About Early Withdrawal Penalties?

Withdrawing earnings before age 59.5 will trigger a 10% federal penalty in addition to regular income tax, if the account is tax advantaged. Annuities funded with non-qualified dollars that are also not within a Roth will not be subject to the age 59.5 rule. Once payments are structured as lifetime income, these penalties generally no longer apply, but this depends on the type of annuity and payout schedule.

How State Taxes Affect Annuity Payments

State income tax rules vary. Some states:

• Fully tax annuity income

• Partially tax annuity income

• Exempt certain retirement income entirely

It’s worth reviewing your state’s rules, especially if you're considering relocating in retirement.

Annuities and Tax Planning: Why It Matters

Understanding annuity taxation isn’t just about compliance. It plays a meaningful role in:

• Preserving purchasing power

• Planning predictable income

• Managing tax brackets in retirement

• Coordinating distributions across multiple accounts

Many investors use annuities not only for stability but also for strategic tax timing, especially when paired with other retirement income sources.

Next Steps: Analyze Your Income Strategy

If you're evaluating how annuity income fits into your retirement plan, the next logical step is to model the numbers for your specific situation.

You can explore how an annuity might affect your overall retirement picture using tools like:

• Our Annuity Calculator

• Our Retirement Income Calculator

• Our Sequence of Return Risk Calculator

• Additional educational resources in our blog library

These tools help you see how different scenarios play out, giving you clarity before making decisions that may impact your long-term financial security.

If you'd like a more personalized walkthrough of how annuity taxation interacts with your broader retirement income strategy, you can also schedule a call below.