November 20, 2025

Learn how annuities are taxed based on type, payout structure, and ownership—essential insights for retirees, estate planners, and beneficiaries.

Annuity Taxation Explained: A Guide for Retirees and Estate Planners

Annuities can be a powerful tool for generating predictable income in retirement and securing long-term financial stability. But while annuities offer important benefits, how they are taxed can be surprisingly complex—and the consequences of misunderstanding those tax rules can be costly.

Whether you’re considering purchasing an annuity, already receiving payments, or planning to pass one on to a beneficiary, it’s crucial to understand how annuities are taxed. Let’s break down the key tax rules surrounding annuities so you can make informed financial decisions.

Types of Annuities and Their Tax Implications

The tax treatment of an annuity largely depends on two things:

1. Whether it’s held in a qualified (tax-advantaged) or non-qualified (after-tax) account
2. The type of payout or withdrawal

Qualified Annuities These are funded with pre-tax dollars, typically through IRAs, 401(k)s, or other retirement accounts. Because the money going into the annuity was never taxed, 100% of any distributions or withdrawals are taxed as ordinary income.

Non-Qualified Annuities These are purchased with after-tax dollars. You won’t be taxed on the principal investment again, but any earnings (interest or growth) are taxed as ordinary income when withdrawn.

How Annuity Payouts Are Taxed

Once annuity payments begin, the IRS uses an “exclusion ratio” to determine how much of each payment is taxable.

• Exclusion Ratio: This is a formula that divides your initial investment by your expected total payout over the annuity’s lifetime. The non-taxable portion (your principal) is excluded from taxes, while the remaining portion (earnings) is taxed as income.

For example, if you invested $100,000 into an annuity and expect to receive $200,000 over your lifetime, half of each monthly payment would be tax-free, and the other half would be taxed.

If the annuitant outlives the expected payout period, the exclusion ratio no longer applies—all subsequent payments are fully taxable.

Withdrawals Before Payout Begins

If you take money out of a non-qualified annuity before you begin annuitizing it (turning it into scheduled payments), the IRS uses a “last in, first out” (LIFO) method. This means earnings are withdrawn first and are fully taxable as ordinary income. After all gains are withdrawn, you can begin withdrawing your tax-free principal.

Important Note: If you withdraw before age 59½, a 10% early withdrawal penalty may also apply on the taxable portion.

Inherited Annuities: What Beneficiaries Need to Know

Beneficiaries of annuities do not get a “step-up” in cost basis like with inherited stocks or real estate. This means they’ll owe taxes on the growth portion of the annuity.

Options for beneficiaries include:

• Lump-sum distribution: Entire amount is received and taxed at once.
• Stretch payments: Spread over several years, allowing taxation over time.
• Five-year rule: Must withdraw the entire balance within five years of the original owner’s death.

The tax impact will vary based on the annuity contract and the relationship to the original owner.

Tax Planning Strategies for Annuity Holders

To optimize tax efficiency, consider these approaches:

• Stagger annuity start dates to manage taxable income in retirement
• Pair annuity withdrawals with other tax strategies, such as Roth conversions or charitable giving
• Consider the annuity’s role in your estate plan, especially if passing it to heirs
• Work with professionals to explore using trusts or other vehicles to help mitigate tax exposure

Final Thoughts: Get Clarity Before You Commit

Annuities can be a smart part of a retirement or legacy strategy—but only if you fully understand the tax consequences. From the timing of withdrawals to how payments are taxed, your choices can significantly impact your financial outcome.

At Omni 360 Advisors and Omni Legacy Law, we help clients align their annuity strategies with their broader estate and financial plans. If you have an annuity—or are considering one—schedule a strategy meeting today to understand how it fits into your tax and legacy picture.

Let’s Talk About Your Annuity Strategy 

Ready to clarify your annuity’s tax implications? Book a strategy session with Omni 360 Advisors or a legacy planning review with Omni Legacy Law.

This blog was developed with the assistance of AI-based tools for research, drafting and editing support (Chat GPT), and reviewed by OMNI 360 personnel for accuracy and relevance.