Are Annuities Taxed as Ordinary Income?

If you are considering an annuity for your retirement portfolio, understanding the tax implications is critical. The short answer to the question "are annuities taxed as ordinary income" is yes. Unlike stocks, bonds, or mutual funds held for more than a year, annuities do not benefit from lower long-term capital gains tax rates. Instead, the earnings you withdraw are taxed at your regular income tax rate, which can be as high as 37% for top earners.

However, the specific amount of your withdrawal that is subject to tax depends entirely on how you funded the account and how you choose to receive the money.

The General Rule: Ordinary Income vs. Capital Gains

The most distinct feature of annuity taxation is that the IRS treats the growth as income rather than investment appreciation. When you sell a stock held for over a year, you typically pay a preferential capital gains tax rate (0%, 15%, or 20%).

In contrast, any gain inside an annuity is tax-deferred, meaning you pay no taxes while it grows. But when you take the money out, those earnings are taxed as ordinary income—the same rate you pay on your wages or salary. This applies to both the interest crediting in fixed annuities and the investment gains in variable annuities.

Tax Treatment by Funding Source

To determine your tax bill, you must first identify if your annuity is "qualified" or "non-qualified."

Qualified Annuities (Pre-Tax Money)

A qualified annuity is purchased with pre-tax dollars, often within a traditional IRA, 401(k), or 403(b). Since you received a tax deduction (or pre-tax treatment) when you contributed the money, the IRS has never taxed those funds.

• Tax Impact: 100% of every withdrawal—both your original contribution and the earnings—is taxed as ordinary income.

• RMDs: These accounts are subject to Required Minimum Distributions (RMDs) once you reach age 73, forcing you to withdraw taxable income whether you need it or not.

Non-Qualified Annuities (After-Tax Money)

A non-qualified annuity is purchased with money you have already paid taxes on (e.g., from a checking or savings account). The IRS will not tax your original contribution (the "principal") again, but it will tax the growth.

• Tax Impact: Only the earnings are taxed as ordinary income. The principal is returned to you tax-free.

How Withdrawals Are Taxed: LIFO vs. Exclusion Ratio

For non-qualified annuities, the method you use to access your cash determines when you pay the tax.

1. Lump Sums and Withdrawals (LIFO)

If you take ad-hoc withdrawals or a lump sum from a non-qualified annuity, the IRS applies a rule known as Last-In, First-Out (LIFO). This means the IRS assumes the first money you take out is your earnings (the "last" money added to the account value).

• Result: You must pay ordinary income tax on every dollar you withdraw until all the earnings are exhausted. Only after you have withdrawn all the gain will you touch your tax-free principal.

2. Annuitization (The Exclusion Ratio)

If you choose to "annuitize" the contract—converting the balance into a guaranteed stream of income for life or a set period—the taxation is more favorable. The IRS uses an exclusion ratio to spread the tax liability over your life expectancy.

• Result: Each payment you receive is considered part taxable income (earnings) and part tax-free return of principal. This prevents a massive tax spike in a single year.

The 10% Early Withdrawal Penalty

In addition to ordinary income tax, the IRS imposes a penalty to discourage using annuities as short-term savings vehicles. If you withdraw earnings from an annuity before age 59½, you will generally owe a 10% penalty tax on top of your regular income tax.

Exceptions to this penalty include:

• Death or total disability of the owner.

• Taking withdrawals as a series of "substantially equal periodic payments" (SEPP) over your life expectancy.

Summary Comparison

While the ordinary income tax treatment is higher than capital gains rates, the benefit of tax deferral allows your money to compound faster during the accumulation phase. For high-income earners who have maxed out other retirement accounts, this trade-off can still be mathematically advantageous depending on their future tax bracket.