Annuity earnings are taxed as ordinary income, not as capital gains. That answer holds whether you’re asking about a variable annuity you bought from an insurer, a fixed annuity inside an IRA, or the payments coming out of an annuitized contract. For 2026, ordinary income rates run from 10% to 37%, while long-term capital gains top out at 20% for most investors.1Internal Revenue Service. Tax Inflation Adjustments for Tax Year 2026 That gap between rate schedules is the real cost of choosing an annuity over a taxable brokerage account, and it applies to the earnings portion of every distribution.
Why the IRS Treats Annuity Growth as Ordinary Income
Capital gains rates apply when you sell a capital asset you’ve held for more than a year, such as stock or real estate.2Internal Revenue Service. Topic No. 409, Capital Gains and Losses Annuity growth isn’t the sale of an asset. It’s interest, bond returns, or sub-account gains that accumulate inside the contract without being taxed year to year. The IRS treats those accumulated earnings as deferred income. When you finally take the money out, it’s taxed at your ordinary rate.
That’s the tradeoff. In a regular brokerage account, you’d owe taxes every year on dividends, interest, and realized gains, and long-held gains would qualify for capital gains rates. Inside an annuity, those taxes are postponed, sometimes for decades. The IRS doesn’t hand out tax deferral and preferential rates at the same time. You get one or the other. Annuities get deferral.
The taxable portion of an annuity distribution stacks on top of your other income for the year, including wages, pensions, and Social Security benefits. Where that lands in the brackets is what you’ll actually pay. For 2026, brackets run from 10% on the first $12,400 of taxable income for a single filer up to 37% on income above $640,600.1Internal Revenue Service. Tax Inflation Adjustments for Tax Year 2026
How Much of Each Withdrawal Is Actually Taxed
“Ordinary income rates” doesn’t mean the full withdrawal is taxable. How much of a given distribution counts as income depends on where the money in the contract came from.
Qualified Annuities (Inside an IRA or 401(k))
A qualified annuity lives inside a tax-advantaged retirement account funded with pre-tax dollars. Because the IRS has never taxed any of the money in the contract, every dollar you withdraw is fully taxable as ordinary income, both your original contributions and the earnings.3Internal Revenue Service. Topic No. 410, Pensions and Annuities There’s no tax-free portion because there’s no after-tax cost to recover. Contribute $200,000, grow the contract to $350,000, and you owe income tax on the full $350,000 as you withdraw it.
Non-Qualified Annuities
A non-qualified annuity is one you bought directly from an insurance company using money you’d already paid income tax on. Only the earnings get taxed on withdrawal. Your original investment, called the cost basis, comes back tax-free.4Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income The earnings piece is still taxed at ordinary rates, not capital gains rates, even though you’re recovering an after-tax investment.
Roth Annuities
An annuity held inside a Roth IRA or a designated Roth 401(k) follows Roth rules. Qualified distributions come out entirely tax-free once you’ve held the Roth account at least five years and are 59½ or older (or the distribution is due to death or disability).3Internal Revenue Service. Topic No. 410, Pensions and Annuities This is the one setup where annuity growth escapes income tax altogether. It’s not capital gains treatment. It’s better than capital gains treatment, because nothing is taxed at all.
Withdrawal Method Changes the Taxable Portion
For a non-qualified annuity, the mechanics of how you take money out determine how much of each distribution the IRS treats as taxable earnings.
Partial Withdrawals: Earnings Come Out First
If you take a partial withdrawal or surrender before converting the contract into a stream of payments, the IRS pulls earnings out first. Any amount received before the annuity starting date is included in gross income to the extent it’s allocable to income on the contract.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Only after you’ve withdrawn all the accumulated earnings do further withdrawals come out tax-free as basis.
Say you invested $100,000 and the contract grew to $140,000. Your first $40,000 in withdrawals is entirely taxable as ordinary income. The remaining $100,000 comes out tax-free.4Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income Early partial withdrawals are often 100% taxable for exactly this reason.
Annuitized Payments: The Exclusion Ratio
When you annuitize a non-qualified contract, converting it into regular payments over your lifetime or a set period, each payment is split into a taxable and tax-free portion using the exclusion ratio. The ratio equals your total cost basis divided by the expected total return.6eCFR. 26 CFR 1.72-4 – Exclusion Ratio
The expected return is figured using IRS life expectancy tables. Invest $100,000, expect $250,000 in total payouts over your projected lifetime, and the exclusion ratio is 40%. Forty percent of every monthly payment is tax-free basis recovery. The remaining 60% is taxable ordinary income. The ratio stays fixed for the life of the payments.
Two tail-end scenarios matter. If you outlive the life expectancy in the calculation, every payment becomes fully taxable once you’ve recovered your entire cost basis. If you die before recovering the full basis, the unrecovered amount is deductible on your final tax return.4Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
Extra Taxes That Can Stack on Top
Ordinary income rates aren’t necessarily the end of the bill. Two additional charges can apply to the taxable portion of an annuity distribution.
The 10% Early Withdrawal Penalty
Withdrawing before age 59½ triggers a 10% additional tax on top of the regular income tax. The penalty applies to the taxable portion of the distribution.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts For a non-qualified annuity, that means the earnings. For a qualified annuity, where the entire withdrawal is taxable, the penalty hits the full amount.
Section 72(q) covers non-qualified annuities, and Section 72(t) covers qualified retirement plan distributions. Both exempt distributions after the owner’s death or due to disability, and both allow penalty-free withdrawals under the Substantially Equal Periodic Payments rule, which requires a calculated payment schedule based on life expectancy for at least five years or until age 59½, whichever comes later.7Internal Revenue Service. Substantially Equal Periodic Payments Section 72(t) has additional exceptions, including distributions for medical expenses exceeding 7.5% of adjusted gross income.5Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The 72(q) list is narrower, so a penalty exception you’ve heard about for IRAs may not apply to a contract you bought directly from an insurer.
The 3.8% Net Investment Income Tax
Higher-income taxpayers pay an additional layer of tax on non-qualified annuity earnings. The taxable portion counts as net investment income under IRC Section 1411, which imposes a 3.8% surtax when modified adjusted gross income exceeds $200,000 for single filers or $250,000 for married couples filing jointly.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax These thresholds are not indexed for inflation.
Qualified plan distributions, including annuities held inside a traditional IRA or 401(k), are explicitly excluded from net investment income.9eCFR. Net Investment Income Tax For someone above the threshold, that’s one place a qualified annuity has an edge.
Inherited Annuities Don’t Get a Step-Up in Basis
One assumption worth clearing up, because it’s often the reason people ask whether annuities get capital gains treatment: annuities do not receive a step-up in basis at the owner’s death. The beneficiary inherits the original owner’s cost basis, and the earnings in the contract remain taxable as ordinary income when distributed.4Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income This is a hard break from the way stocks and real estate work at death, and it catches heirs off guard.
For non-qualified inherited contracts, only the earnings above the cost basis are taxable. For qualified inherited contracts, the entire distribution is ordinary income. The tax character is the same one the original owner would have faced. What changes is the timing, which depends on the beneficiary’s relationship to the deceased and the type of annuity.4Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
The bottom line for anyone comparing an annuity to a taxable investment: the growth doesn’t qualify for the 0%, 15%, or 20% long-term capital gains brackets at any point. It’s ordinary income going in, ordinary income coming out, and ordinary income when a beneficiary inherits it. Deferral is the benefit. Rate treatment isn’t.