How Annuities Are Taxed: Qualified vs. Non-Qualified Contracts

A plain-English guide to IRS rules for annuity withdrawals, income payments, the additional 10% tax before 59½, exchanges and death benefits.

Annuity Grader · Last reviewed October 26, 2026 · 5 min read

Tax deferral is one of the main reasons people buy annuities, but deferral is not the same as tax-free. Sooner or later, the earnings in an annuity are taxed, and how they are taxed depends on where the money came from, how you take it out and when.

This guide summarizes the federal rules the IRS describes in Publication 575 (2025), Pension and Annuity Income, and related IRS pages. It is general information, not tax, financial, insurance or legal advice. Federal tax law changes, state taxes may also apply, and your situation may have details these rules don't cover, so check with a qualified tax professional before acting, and take questions about the contract itself to the insurer or your state insurance department.

Qualified vs. non-qualified: what the labels mean

In everyday use, a qualified annuity is one held inside a tax-favored retirement arrangement, such as an employer plan or an IRA. A non-qualified annuity is one you buy on your own; Publication 575 describes a nonqualified plan as including a contract you bought directly from the issuer.

The label changes almost everything about how withdrawals are taxed. One point regulators stress: Investor.gov (as viewed in October 2026) says that if you invest in an annuity through a tax-deferred retirement plan such as a traditional 401(k) or IRA, you do not get any additional tax deferral; the annuity is taxed like any other investment in the plan. For amounts received from an IRA, Publication 575 points readers to IRS Publication 590-B.

While the money stays inside

Investor.gov says you pay no taxes on interest or investment gains in an annuity until you withdraw money, receive income payments or a death benefit is paid. For variable annuities, it adds that you can generally move money between investment options without paying federal tax at the time of the transfer.

When gains do come out, Publication 575 says the taxable part of a distribution is treated as ordinary income. Investor.gov's variable annuity page makes the consequence explicit: you pay tax on the gains at ordinary income tax rates rather than lower capital gains rates.

Withdrawals before annuity payments begin

Publication 575 (2025) sets out the order in which withdrawals are taxed before your annuity starting date:

Non-qualified contract: the amount withdrawn is allocated first to earnings, which are taxable, and then to your cost, which is tax-free. Contracts bought before August 14, 1982, follow a different allocation for investment made before that date.
Qualified plan: a ratable part of the withdrawal is tax-free, based on the ratio of your cost to your account balance.
Full surrender: the amount you receive is tax-free to the extent of any cost you haven't already recovered tax-free; the rest is taxable.

Borrowing against a contract can also count. Publication 575 says a loan under a commercial annuity contract, or pledging part of your interest in it, is generally treated as a distribution.

Annuity payments

Once you annuitize, each payment is usually part return of your cost and part taxable income. For non-qualified annuities, Publication 575 says you must use the General Rule, which figures the tax-free part of each payment from the ratio of your cost to your expected return, using IRS life expectancy tables; IRS Publication 939 explains the computation. If your annuity starting date is after 1986, Publication 575 says the total you can exclude over the years can't exceed your cost; after that, payments are generally fully taxable. Any cost still unrecovered at death is allowed as an itemized deduction on the decedent's final return.

For qualified plans, IRS Topic 410 (as viewed in October 2026) says payments are fully taxable if you have no investment in the contract, for example because you never contributed after-tax money, and partially taxable if you did.

The additional 10% tax before age 59½

For 2025 returns, Publication 575 says most distributions from qualified retirement plans and nonqualified annuity contracts made before age 59½ are subject to an additional 10% tax on the part you must include in income. It doesn't apply to tax-free amounts such as a return of your cost.

General exceptions listed in Publication 575 include distributions that are part of a series of substantially equal periodic payments, distributions because you are totally and permanently disabled, distributions after a physician certifies terminal illness, and distributions on or after the death of the contract holder. Nonqualified contracts have additional exceptions, including payments from an immediate annuity, which Publication 575 defines as a single-premium contract with substantially equal payments starting within one year of purchase and paid at least annually.

Exchanges and 1035 transfers

You can sometimes move from one annuity to another without triggering tax. Publication 575 says no gain or loss is recognized when an annuity contract is exchanged for another annuity contract if the insured or annuitant remains the same. A partial transfer of an annuity's cash surrender value to a new contract from another insurer can also qualify, but the funds must be transferred directly between the insurance companies. These are often called 1035 exchanges, after the section of the tax code that allows them, as an archived SEC publication on variable annuities (captured in March 2019) explains. Going the other direction has a catch: if an annuity is exchanged for a life insurance contract, Publication 575 says any gain from accumulated interest is ordinary income.

A tax-free exchange is not a cost-free exchange. Investor.gov warns that you may pay a surrender charge on the old contract and start a new surrender period on the new one.

When the owner dies, and other taxes

For 2025 returns, Publication 575 says a beneficiary generally reports annuity income the same way the owner would have. If the owner died before the annuity starting date of a deferred annuity, the amount the beneficiary receives above the owner's cost is included in the beneficiary's income as income in respect of a decedent, for which an estate tax deduction may be available.

Publication 575 says annuities under a nonqualified plan are included when figuring net investment income for the Net Investment Income Tax. IRS Topic 410 says the taxable part of pension or annuity payments is generally subject to federal income tax withholding, and you can use Form W-4P to choose how much is withheld. Investor.gov notes there may also be state tax implications.

Key takeaways

Qualified annuities sit inside retirement plans or IRAs and add no extra tax deferral; non-qualified annuities are bought on your own, outside those plans.
Non-qualified withdrawals before annuitizing come out earnings first, and gains are taxed as ordinary income.
Annuity payments from a non-qualified contract are split into a tax-free return of cost and taxable income.
Withdrawals before age 59½ can trigger an additional 10% tax on the taxable part unless an exception applies (IRS Publication 575, 2025 returns).
Annuity-to-annuity exchanges can be tax-free under IRS rules, but surrender charges and new surrender periods may still apply.

Sources

Our articles are general information, not financial, insurance, tax or legal advice, and we don't sell insurance or recommend specific companies or products.

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