How your annuity income is taxed depends mostly on one question: where did the money come from?
Qualified money: IRA, 401(k), 403(b)
If you buy an annuity with pre-tax retirement money, you never paid income tax on it. So every dollar of annuity income is taxed as ordinary income when you receive it — the same as a regular IRA withdrawal. Annuity payments from an IRA can also help satisfy required minimum distributions.
Non-qualified money: savings, CDs, a brokerage account
If you use money you’ve already paid tax on, part of each payment is simply your own money coming back to you — and that part isn’t taxed again. The IRS uses the exclusion ratio to decide how much.
A simplified example (illustration only):
You put $100,000 of savings into a SPIA at 65. It pays $600 a month. The IRS expects a 65-year-old to collect for about 20 years, so you’d expect about $144,000 in total.
$100,000 ÷ $144,000 ≈ 69%. So about 69% of each check — around $415 — is a tax-free return of your money. Only about $185 a month is taxable. Once you’ve recovered your full $100,000, later payments become fully taxable.
This example is simplified. Actual exclusion-ratio calculations follow IRS rules (Publication 939), including the IRS’s life-expectancy tables, and your contract’s details. Your insurer reports the taxable amount each year.
This is one reason SPIAs bought with savings can be more tax-efficient than many people expect: in the early years, much of the income is your own principal returning.
Roth IRA money and after-tax (basis) money
Not all retirement-account money is pre-tax. An annuity held inside a Roth IRA generally pays income tax-free, as long as the payments are qualified Roth distributions (generally, the Roth has been open at least five years and you’re 59½ or older). And if a traditional IRA or employer plan includes after-tax contributions — your “basis” — the part of each payment that returns that basis isn’t taxed again; only the rest is. IRA basis is tracked on IRS Form 8606, so keep those records.
A few other points
- Growth inside deferred annuities (like MYGAs and FIAs) isn’t taxed until you take it out.
- Withdrawals before 59½ may face a 10% IRS penalty on the taxable part, with some exceptions — including a qualifying series of immediate-annuity payments.
- State taxes vary. A few states have no income tax; some treat retirement income differently.
We aren’t tax advisors, and this is general information, not tax advice. Your tax professional can tell you how this applies to you — and we’re happy to talk with them too.
