Yes, annuity payments are considered income for tax purposes, but whether the whole payment is taxable or only part of it depends on how you funded the contract. Money that went in pre-tax comes out fully taxable as ordinary income. Money that went in after-tax comes back partly tax-free, because you already paid tax on your original investment. On top of that base rule, annuity income can pull in a 3.8% surtax, raise your Medicare premiums, and make more of your Social Security benefits taxable.
Qualified vs. Non-Qualified Annuities
The single biggest factor in how your payments are taxed is whether the annuity is qualified or non-qualified.
A qualified annuity sits inside a tax-advantaged retirement account like a traditional IRA or 401(k). You contributed pre-tax dollars and never paid income tax on the money going in, so you have zero cost basis in the contract. Every dollar of every payment is taxable as ordinary income.1Internal Revenue Service. Topic No. 410, Pensions and Annuities
A non-qualified annuity is one you bought directly from an insurance company with money you had already paid tax on. You have a cost basis equal to what you put in, and the IRS lets you recover that basis tax-free over the life of the contract. Only the earnings portion of each payment is taxable.2Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
An annuity held inside a Roth IRA is a separate case. Because Roth contributions were made with after-tax dollars, qualified distributions come out completely tax-free once you’re over 59½ and the account has been open at least five years.
How the Taxable Portion Is Calculated
For non-qualified annuities, the IRS uses an exclusion ratio to split each payment into a taxable piece and a tax-free piece. You figure out what percentage of the contract’s total expected payout represents your original investment, and that same percentage of every payment comes back to you tax-free.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The math needs two numbers. Your investment in the contract is the total after-tax premiums you paid, minus anything you previously received tax-free. Your expected return is the annual payment multiplied by a life expectancy factor from IRS actuarial tables based on your age when payments start. Divide investment by expected return, and you have the ratio.
Say you put $100,000 into an annuity and your expected return based on life expectancy is $250,000. Your exclusion ratio is 40%. Forty cents of every dollar you receive is a tax-free return of principal; the other sixty cents is taxable ordinary income. The ratio is fixed once calculated and applies to every payment.4eCFR. 26 CFR 1.72-1 – Introduction
What Happens After You Recover Your Full Basis
The ratio doesn’t run forever. Once the total tax-free amounts you’ve received equal your original investment, you’ve recovered your basis. From that point forward, every dollar the annuity pays is fully taxable. If you outlive the actuarial projection, those extra years of payments are 100% taxable income.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
If Payments Stop Before Basis Is Recovered
The reverse case works in the annuitant’s favor. If payments end because the annuitant dies and there is still unrecovered basis in the contract, the remaining basis becomes a tax deduction on the annuitant’s final return. If a beneficiary continues receiving payments, that beneficiary claims the deduction in the year they receive the final payments.3Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
Withdrawals Before Annuitization Are Taxed Differently
The exclusion ratio only applies once the contract has been annuitized into a regular payment stream. If you pull money out before that, either as a partial withdrawal or a full surrender, the IRS uses a much less favorable rule: earnings come out first.
Under this income-first approach, every dollar you withdraw is treated as taxable earnings until you’ve pulled out all the accumulated gains. Only after the earnings are exhausted does further withdrawal become a tax-free return of principal.2Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income Early withdrawals therefore hit your tax return harder than regular annuity payments, where basis is spread evenly.
There’s also an aggregation rule to watch. If you own multiple non-qualified annuities purchased from the same insurance company (or its affiliates) in the same calendar year, the IRS treats them as a single contract for withdrawal purposes.5Internal Revenue Service. Revenue Ruling 2007-38 You cannot withdraw from a high-basis contract and leave gains sitting untouched in another. Earnings across the aggregated contracts are pooled, and the income-first rule applies to the combined total.
The 10% Penalty for Early Distributions
On top of ordinary income tax, the IRS charges an additional 10% tax on taxable distributions taken before age 59½. This applies to both qualified and non-qualified annuities.2Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
Several exceptions let you avoid the penalty:
- Distributions made because of the owner’s death or total and permanent disability.
- A series of substantially equal periodic payments calculated on your life expectancy. Once started, the series must continue for at least five years or until you turn 59½, whichever comes later.
- Distributions made after a physician certifies you have a terminal illness.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
- Up to $5,000 per child for qualified birth or adoption costs, available from both qualified plans and IRAs.6Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
The penalty is reported on Schedule 2 of your Form 1040 when your 1099-R shows distribution code “1” in box 7. Otherwise you’ll file Form 5329 to claim an exception.
Other Taxes Annuity Income Can Trigger
Adding annuity income to your return can move you across thresholds that matter for other parts of your tax and benefits picture.
The 3.8% Net Investment Income Tax
Higher-income taxpayers face an additional 3.8% tax on net investment income, and the taxable portion of non-qualified annuity payments counts. The tax kicks in when modified adjusted gross income exceeds $200,000 for single filers, $250,000 for married couples filing jointly, or $125,000 for married individuals filing separately.7Internal Revenue Service. Net Investment Income Tax These thresholds are not indexed for inflation. The tax applies to the lesser of your net investment income or the amount by which MAGI exceeds the threshold.8Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
Distributions from qualified retirement plans, traditional IRAs, and Roth IRAs are excluded from net investment income. The 3.8% surtax only reaches non-qualified annuity earnings.
Medicare Premiums (IRMAA)
The taxable portion of annuity payments flows into the MAGI figure that Medicare uses to set income-related monthly adjustment amounts on Part B and Part D premiums. The surcharge is based on income from two years prior, so a large distribution in 2024 affects 2026 premiums.
For 2026, the standard Part B premium is $202.90 per month. Higher-income tiers push it up considerably:9Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
- Single filers above $109,000 (joint above $218,000) start paying IRMAA, adding $81.20 per month to Part B and $14.50 to Part D.
- Single filers above $205,000 (joint above $410,000) see the Part B surcharge reach $446.30 monthly, bringing the total to $649.20.
- Single filers at $500,000 or above (joint at $750,000 or above) hit the maximum surcharge of $487.00 per month on Part B alone.
Part D carries parallel surcharges at the same income tiers, topping out at $91.00 per month. A lump-sum surrender or large one-time withdrawal can lift you into a higher bracket for two years of premiums.
Taxable Social Security Benefits
If you receive Social Security, annuity income can make more of those benefits taxable. The IRS uses “combined income,” which is your adjusted gross income, nontaxable interest, and half of your Social Security benefits. Pension and annuity income counts toward that total.10Internal Revenue Service. IRS Reminds Taxpayers Their Social Security Benefits May Be Taxable
For single filers, combined income above $25,000 makes up to 50% of Social Security benefits taxable; above $34,000, up to 85%. For married couples filing jointly, the thresholds are $32,000 and $44,000. The thresholds have not been adjusted for inflation since 1984 and 1993, so even a modest annuity stream can shift the calculation.
What Beneficiaries Owe on an Inherited Annuity
When an annuity owner dies, the tax treatment for the person who inherits it depends on the relationship.
A surviving spouse generally has the most options. For qualified annuities, the spouse can roll the contract into their own IRA and keep the tax deferral going until their own required distribution age.2Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income For non-qualified annuities, many insurers allow spousal continuation, where the surviving spouse becomes the new owner and the contract keeps growing tax-deferred.
For deaths after 2019, most non-spouse beneficiaries can no longer stretch distributions over their own life expectancy. Under the SECURE Act, they must empty the account by the end of the tenth year following the year of death.11Internal Revenue Service. Retirement Topics – Beneficiary A narrower group of “eligible designated beneficiaries” can still use the life-expectancy method: the owner’s minor children (until they reach majority), disabled or chronically ill individuals, and anyone no more than ten years younger than the deceased owner.
One point that surprises heirs: annuities do not receive a stepped-up basis at death. The original owner’s cost basis transfers to the beneficiary, who owes ordinary income tax on all the accumulated, untaxed earnings as they take distributions.11Internal Revenue Service. Retirement Topics – Beneficiary The beneficiary can still exclude the basis portion of each payment, but there is no fresh start the way there is with inherited stock or real estate.
How the Income Shows Up on Your Return
Every annuity distribution is reported on Form 1099-R, which the insurance company sends you each January for the prior year.12Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025) The boxes that matter:
- Box 1 shows the gross distribution, the total amount paid before withholding.
- Box 2a shows the taxable amount. The difference between Box 1 and Box 2a is your tax-free return of basis.
- Box 4 shows any federal income tax the insurer withheld.
- Box 7 carries a distribution code identifying the type of payment, including whether it’s an early distribution subject to the 10% penalty.
If Box 2a is blank, the insurer couldn’t calculate the taxable amount and you’ll need to figure it yourself using the exclusion ratio. Keep records of total premiums paid and any prior tax-free amounts received, because that documentation is what makes the calculation possible when the time comes.