How Are Annuities Taxed?

Annuities grow tax-deferred—but how much you’ll owe depends on whether they’re qualified or non-qualified, and who inherits them.

It's important to understand the difference between qualified and non-qualified annuities. Vitalii Vodolazskyi/Shutterstock

Annuities offer tax-deferred growth, but taxes are eventually owed on withdrawals. Taxes on annuities are based on whether they are qualified or non-qualified funds.

But what is the difference between a qualified and a non-qualified annuity? And if you aren’t a spouse and inherit an annuity, what are the tax ramifications?

Qualified vs. Non-Qualified Annuities

A qualified annuity is a retirement savings account that is funded with pretax dollars. For example, the funds you contribute to a 401(k) plan or individual retirement account (IRA) are considered qualified annuities.

A non-qualified annuity is funded with after-tax dollars. It is typically held outside of a retirement account, for example, a Roth IRA. Contributions made to a non-qualified annuity are not tax-deductible.

Taxing a Qualified Annuity

With a qualified annuity, savings are funded with pretax dollars, and neither contributions nor earnings are subject to income tax until retirement, when withdrawals are made.

Because you didn’t pay tax on the initial income that you contributed to the qualified annuity, when you withdraw, you’ll need to pay taxes on both the contribution and any investment gains.

Distributions (withdrawals) from a qualified annuity are taxed as ordinary income. The tax depends on your income bracket. The theory is that when you retire, you’ll have less income and, therefore, be in a lower income tax bracket.

Employers of a company-sponsored retirement plan typically set up qualified plans. The different plans include:

• 401(k)—set up by a for-profit company. The SECURE Act of 2019 allowed annuities to be included in 401(k) plans
• Defined benefit plan (pensions)
• 403(b)—available primarily to teachers and other public employees, as well as workers at tax-exempt organizations
• IRA—Allows a pretax contribution with annual limits. The 2025 limit, according to the Internal Revenue Service (IRS) is $7,000 with an additional $1,000 for catch-up contributions.

Once you start withdrawals from one of these qualified annuities, you are taxed on the distribution as ordinary income.

Taxing a Non-Qualified Annuity

Non-qualified annuities are funded with after-tax dollars and are not usually held in a retirement account. Contributions aren’t tax-deductible. An example of a non-qualified annuity is a Roth IRA or various insurance products.

Although you are paying tax on the front end of the annuity, the earnings on your subaccounts grow tax deferred. This is the unique tax advantage of a non-qualified annuity.

According to the IRS, “Beginning in 2013, distributions from an annuity under a non-qualified plan are considered net investment income for the purpose of figuring the net investment income tax.”

In other words, only the net gain or earnings on your investment are taxable. You’ve already paid taxes on the money that you invested. You can’t be taxed twice.

As a result, a portion of each payment made to you is treated as principal for tax purposes. To calculate this, the nontaxable portion of each payment is determined by the ratio of your investment in the annuity to the current account balance. A formula is available with the IRS. The insurance company will report the annual payouts to you and the IRS on Form 1099-R.

The portion you will be taxed on will be considered ordinary income using your income bracket. Owners of non-qualified annuities are not required to take required minimum distributions (RMDs) from their accounts.

Inherited Annuities Tax Ramifications for Spouses

For spouses who inherit their partner’s annuity, there are several options available. You can step in as the new owner or annuitant, and the contract continues as if nothing happened. You must notify the insurance company if you wish to do this. There is no immediate taxation, and it defers RMDs. It keeps the tax-advantaged growth going.

You could also take the full balance, but you’ll owe taxes immediately on the taxable portion if it’s a non-qualified annuity. You’ll be responsible for taxes on the entire amount if it is a qualified annuity.

Or you could convert the balance into guaranteed income over your lifetime or specific term. You would only pay taxes on the taxable portion of each payment.

All taxation is based on your ordinary income.

Inherited Annuities Tax Ramifications for Non-Spouse Beneficiaries

According to the IRS, the five-year rule applies to non-designated beneficiaries like an estate, charity, or certain trusts, when the IRA owner dies before their required beginning date for RMDs. It requires that the entire IRA be emptied by the end of the fifth year following the year of the owner’s death.

For example, if the owner died in 2024, the beneficiary must fully distribute the IRA by Dec. 31, 2029. The beneficiary will be taxed on the taxable portion of ordinary income.

There are no annual withdrawal requirements; just that the whole account must be emptied before the deadline.

IRS 10-Year Rule

If a non-spouse inherits the IRA, they can’t keep the money growing forever. Instead, they must empty the account by Dec. 31 of the tenth year after the owner’s death. For example, if the owner died in 2024, the account must be drained by Dec. 31, 2034.

The 10-year rule applies to most designated beneficiaries, like individuals named on the account (siblings, friends), children, or grandchildren. In other words, anyone who doesn’t meet “eligible designated beneficiary” status. It has been the default since the 2019 SECURE Act.

The 10-year rule doesn’t change the tax hit; it merely sets a deadline. Each withdrawal is taxable income and taxed based on your ordinary income.

Qualified and Non-Qualified Annuities

It’s imperative from a tax perspective to understand the difference between qualified and non-qualified annuities.

Because you’ve paid taxes on the contributions for non-qualified annuities, you won’t be taxed on the principal only on the returns. However, a qualified annuity had pretax contributions and therefore any amount that you withdraw will be taxed.

Taxes are based on your ordinary income rate.

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