One of the most cited benefits of annuities is their tax treatment. The details differ depending on whether the annuity is funded with pre-tax or after-tax money, so it helps to separate the two.

Tax-deferred growth

Unlike a taxable brokerage account, growth inside an annuity isn’t taxed year to year. You only owe tax when you actually take money out, which allows the full account value (including money that would otherwise go to taxes each year) to keep compounding in the meantime.

Qualified vs. non-qualified money

A qualified annuity is funded with pre-tax retirement money (like an IRA rollover). Every dollar withdrawn is generally taxed as ordinary income, the same as it would be coming out of the IRA directly. A non-qualified annuity is funded with after-tax money. Withdrawals are taxed under “last in, first out” (LIFO) rules, meaning growth is considered withdrawn first and taxed as ordinary income, while your original after-tax contribution comes out tax-free once the growth portion is exhausted.

How annuitized income payments are taxed

When a non-qualified annuity is converted into a stream of income payments, each payment is generally split between a tax-free return of your original principal and a taxable portion representing growth, using what’s called an exclusion ratio, until the principal is fully recovered.

Early withdrawal penalty

Withdrawals of taxable gains before age 59½ are generally subject to a 10% federal early withdrawal penalty, in addition to ordinary income tax, similar to early withdrawals from an IRA or 401(k).

This article is educational and general in nature. It isn’t personalized tax advice. Consult a tax professional about your specific situation.