How Are Immediate Annuities Taxed: Exclusion Ratio and RMDs

Immediate annuities are taxed one payment at a time, and how much of each payment is taxable depends on where the money you used to buy the contract came from. If you funded it with after-tax savings, each payment is split between a tax-free return of your principal and taxable earnings, using a fixed percentage called the exclusion ratio. If you funded it with pre-tax retirement money, every dollar is taxed as ordinary income. Roth money produces payments that are generally tax-free. The rules below walk through each case, plus the penalties, surtaxes, and reporting mechanics that ride alongside.

Non-Qualified Annuities: The Exclusion Ratio

A non-qualified immediate annuity is one you buy with money you’ve already paid income tax on, such as ordinary savings or brokerage proceeds. The IRS doesn’t tax that principal a second time when it comes back to you, so each check blends tax-free principal with taxable earnings in a proportion that’s locked in when payments begin and doesn’t move for the life of the contract.¹²

The formula is simple: divide your investment in the contract (the premium you paid) by the expected return (what you’re statistically expected to receive over the life of the annuity).³ How you calculate the expected return depends on the payout structure:

For a life annuity, multiply your annual payment by the life expectancy factor the IRS assigns to your age. For annuities starting after June 1986, the IRS uses unisex Tables V through VIII in Publication 939.⁴
For a period-certain annuity, multiply the payment amount by the guaranteed number of payments. A 10-year certain annuity paying $600 a month has an expected return of $72,000.
For a joint and survivor annuity, use the joint life expectancy factor from the appropriate IRS table based on both annuitants’ ages.

A Worked Example

Say you’re 65 and buy a non-qualified immediate annuity for $100,000 that pays $500 a month for life. The Table V life expectancy factor at age 65 is 20.0, so the expected return is $120,000 ($500 × 240 monthly payments). The exclusion ratio is $100,000 ÷ $120,000, or 83.33%. That means $416.65 of every $500 payment is tax-free and the remaining $83.35 is taxable as ordinary income.⁵

The tax-free treatment has a stopping point. Once you’ve received back every dollar of your original premium through the exclusion (in this example, after 240 payments), all future payments become fully taxable. If you outlive your statistical life expectancy, the checks keep coming, but the tax break doesn’t.

Qualified Annuities: Fully Taxable

A qualified immediate annuity is funded with pre-tax retirement money, typically a rollover from a traditional IRA, 401(k), or 403(b). Because no income tax was ever paid on those contributions or their growth, every dollar coming out is taxed as ordinary income at your marginal rate. There’s no exclusion ratio because there’s no after-tax cost basis to recover.¹

One narrow exception: if your retirement account contained non-deductible contributions (this sometimes happens with traditional IRAs), that portion does carry a cost basis. The exclusion ratio then applies only to the slice of the annuity attributable to those after-tax dollars, and the rest remains fully taxable.

Roth-Funded Annuities

If you buy an immediate annuity with a rollover from a Roth IRA, the payments are generally tax-free, provided you’re at least 59½ and at least five years have passed since your first Roth IRA contribution. Roth contributions were made with after-tax dollars, and once the qualified distribution rules are met, neither the return of principal nor the earnings triggers federal income tax.

The 10% Early Withdrawal Penalty Usually Doesn’t Apply

Federal tax law imposes a 10% penalty on taxable annuity distributions taken before age 59½, but immediate annuities are carved out. IRC 72(q)(2)(I) exempts payments from an immediate annuity contract from the penalty entirely, and 72(q)(2)(D) separately exempts substantially equal periodic payments made over your life expectancy, which describes how most immediate annuities work.³ A 55-year-old who buys a SPIA and starts collecting monthly payments won’t face the 10% penalty, even though they’re well under 59½.

The 3.8% Net Investment Income Tax

The taxable portion of non-qualified annuity income counts as net investment income for purposes of the 3.8% surtax under IRC 1411.⁶ The surtax applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly). If your annuity income pushes you past those thresholds, you’ll owe an extra 3.8% on the lesser of your net investment income or the amount above the threshold.

Distributions from qualified retirement plan annuities (traditional IRAs, 401(k)s, 403(b)s) are excluded from net investment income entirely, so the surtax doesn’t touch them.⁷ Qualified annuity holders catch a break here even though every dollar of their payment is otherwise taxable.

If You Die Before Recovering Your Basis

If you die before receiving back your full investment through the exclusion ratio, the unrecovered amount isn’t lost. For annuities with a starting date after 1986, the remaining cost basis is allowed as an itemized deduction on your final tax return.³

Take the earlier example. If you invested $100,000, recovered $9,600 a year through the exclusion, and died after eight years, you’d have received $76,800 tax-free. The remaining $23,200 of unrecovered investment would be deductible on your final return.⁵

How Beneficiaries Are Taxed

Many immediate annuities include a guaranteed period or refund feature that continues payments to a beneficiary after the annuitant dies. Tax treatment depends on the annuity type.

For a non-qualified annuity with remaining cost basis, the beneficiary continues to use the original exclusion ratio until the full investment is recovered. Once recovered, all remaining payments are fully taxable. If the contract has no surviving payment feature and payments simply stop, the unrecovered basis deduction described above applies instead.³

For a qualified annuity, beneficiary payments remain 100% taxable as ordinary income. There’s no cost basis to recover, so every dollar the beneficiary receives is included in gross income.

RMDs for Qualified Annuities

If your immediate annuity was bought with pre-tax retirement funds, it’s subject to required minimum distribution rules. Under the SECURE 2.0 Act, RMDs must begin by age 73 for individuals born between 1951 and 1959, and by age 75 for those born in 1960 or later.⁸

The annuity payments themselves count toward your RMD obligation. The insurance company sets a year-end fair market value for the annuity, and the annual income from the annuity is compared against the RMD calculated from that value. If your annuity payments exceed the RMD attributable to the annuity, the excess can help satisfy RMD requirements for other retirement accounts you own, such as a separate traditional IRA.

Non-qualified annuities bought with after-tax money aren’t subject to RMD rules at all.

Withholding and Reporting

Your annuity issuer will withhold federal income tax from each payment unless you tell them otherwise. You control the amount by filing Form W-4P with the payer. If you never submit a W-4P, the payer withholds as if you’re a single filer with no adjustments, which often means more tax withheld than necessary for married filers or those with significant deductions.⁹ You can elect zero withholding on the same form. If you do, plan to make quarterly estimated payments; if you under-withhold and owe more than $1,000 at filing time, you could face an estimated tax penalty.

The issuer reports your payments each year on Form 1099-R, which you’ll receive by January 31.¹⁰ The key boxes:

Box 1 (Gross Distribution) shows the total amount paid to you during the year.
Box 2a (Taxable Amount) shows the portion you must include in gross income. For non-qualified annuities, this reflects the exclusion ratio already applied. For qualified annuities, it usually matches Box 1.¹¹
Box 5 (Employee Contributions) shows your after-tax investment in the contract, if any.

You report the taxable amount from Box 2a on Form 1040 as ordinary income. If you believe the issuer applied the exclusion ratio incorrectly, which happens occasionally with contracts that have been transferred between insurance companies, you can calculate the correct amount yourself using IRS Publication 939 and report the adjusted figure. Keep your original annuity contract and premium records to support your calculation.⁴

State Taxes

Federal tax isn’t the whole picture. Most states with an income tax also tax annuity payments as ordinary income, though a handful offer partial exclusions for pension and annuity income. These exclusions vary: some states exempt a fixed dollar amount of retirement income, others exempt none. A few states have no income tax at all. Check your state’s rules before assuming your federal treatment settles the question.

1
Internal Revenue Service. Topic No. 410, Pensions and Annuities
2
eCFR. 26 CFR 1.72-4 – Exclusion Ratio
3
Office of the Law Revision Counsel. 26 US Code 72 – Annuities, Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Publication 939, General Rule for Pensions and Annuities
5
Internal Revenue Service. Publication 575, Pension and Annuity Income
6
Internal Revenue Service. Net Investment Income Tax
7
eCFR. 26 CFR Part 1 – Net Investment Income Tax
8
Congress.gov. Required Minimum Distribution (RMD) Rules for Original Account Holders
9
Internal Revenue Service. Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments
10
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
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Internal Revenue Service. Instructions for Forms 1099-R and 5498