Interest and other earnings inside a nonqualified annuity are not taxed while they sit in the contract. They compound tax-deferred, and the IRS takes its cut only when money comes out. At that point the earnings are taxed as ordinary income at your regular rate, not at the lower long-term capital gains rate. Because you funded the contract with after-tax dollars, the money you originally put in (your basis) comes back to you tax-free; only the growth above that basis is taxable. How the taxable portion is measured depends on whether you withdraw casually, convert the contract into a stream of payments, or leave it to a beneficiary.
Why Interest Isn’t Taxed Year to Year
The core tax feature of a nonqualified annuity is deferral. Interest credited to a fixed contract, dividends and capital gains inside a variable contract, and any index-linked growth all accumulate without producing a 1099 each year. Nothing hits your return until a distribution occurs. That lets the full pre-tax balance keep working, which over long holding periods can outperform a taxable brokerage account earning the same return.
Deferral is not forgiveness. The IRS collects eventually, and it collects at ordinary income rates. Long-term capital gains rates and qualified dividend rates don’t apply to annuity earnings, even if the underlying subaccounts held stocks. That rate disadvantage is the trade-off for the deferral, and it’s the reason nonqualified annuities generally make sense only when held for many years.
Your basis is the total of after-tax dollars you paid in. The insurance company tracks it and reports any taxable distribution on Form 1099-R, which arrives by late January of the following year.1Internal Revenue Service. About Form 1099-R
How Withdrawals Are Taxed
If you take money out without annuitizing, the tax code applies a last-in, first-out rule. Earnings come out before basis. Every dollar you pull is fully taxable as ordinary income until the entire accumulated earnings balance is exhausted; only after that do further withdrawals count as a tax-free return of principal.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
An example makes the point. Say you invested $100,000 and the contract has grown to $150,000. Withdraw $30,000 and the entire $30,000 is taxable, because it’s drawn from the $50,000 of accumulated earnings. You would need to withdraw more than $50,000 before any portion could be treated as a nontaxable return of your $100,000 basis. That front-loading of taxable income is the biggest drawback of taking money out piecemeal.
The 10% Early Withdrawal Penalty
On top of ordinary income tax, the taxable portion of a distribution taken before age 59½ is hit with an additional 10% tax. This penalty is imposed by the annuity provisions of the code and is separate from the early withdrawal penalty that applies to IRAs and 401(k) plans, which matters because the exception list is different.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
The 10% penalty does not apply to distributions:
- Taken after age 59½
- Made after the contract holder’s death
- Attributable to the holder’s disability (permanent inability to engage in substantial gainful activity)
- That are part of a series of substantially equal periodic payments over the holder’s life expectancy
- From an immediate annuity
- Allocable to investment in the contract before August 14, 1982
Exceptions available for retirement accounts, such as unreimbursed medical expenses or higher education costs, do not carry over to nonqualified annuities.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts The substantially equal periodic payments route is the most commonly used workaround for people who need access before 59½; the payments must be calculated under one of three IRS-approved methods and continued for the longer of five years or until age 59½, or the penalty is recaptured on every payment already taken.3Internal Revenue Service. Substantially Equal Periodic Payments
How Annuitized Payments Are Taxed
The tax math changes if you convert the contract into a guaranteed stream of periodic payments. Instead of LIFO squeezing all earnings out first, each payment is split into a taxable portion and a nontaxable return of basis using an exclusion ratio.
The ratio is your investment in the contract divided by the expected return. The expected return is your annual payment amount multiplied by your life expectancy on the annuity starting date, taken from IRS actuarial tables.4Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities If you invested $100,000 and the tables project a total expected return of $200,000, your exclusion ratio is 50%. Half of every payment comes back as tax-free basis, and the other half is taxable ordinary income. The ratio is fixed on the annuity starting date and applies to every payment.
Two edge cases matter. Once your cumulative tax-free returns equal your full basis, the exclusion runs out and every subsequent payment is 100% taxable. Someone who outlives their life expectancy will reach that point and see their after-tax income drop. Going the other way, if the annuitant dies before recovering the full basis, the unrecovered amount can be claimed as a deduction on the final tax return.4Internal Revenue Service. Publication 939 – General Rule for Pensions and Annuities
The 3.8% Net Investment Income Tax
Taxable annuity income can also trigger the net investment income tax, an additional 3.8% surtax that catches many contract owners off guard. It applies to the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds $200,000 for single filers, $250,000 for married couples filing jointly, or $125,000 for married filing separately.5Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
Annuity income is explicitly listed as net investment income in the statute. While the contract sits in accumulation and produces no distributions, the surtax has nothing to grab. Once withdrawals or annuity payments begin, the taxable portion both raises your MAGI and counts toward the tax base. A large lump-sum withdrawal can push you over the threshold in a single year even if you’re normally well below it. The thresholds are not indexed for inflation and have not moved since the tax was enacted in 2013.5Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax
What Happens at the Owner’s Death
Nonqualified annuities do not get a stepped-up basis when the owner dies. The tax code specifically excludes them.6Office of the Law Revision Counsel. 26 U.S. Code 1014 – Basis of Property Acquired From a Decedent The beneficiary inherits the contract with the original basis intact, receives that basis tax-free, and pays ordinary income tax on all of the accumulated earnings as they’re distributed.
The code requires the contract to be paid out under one of three frameworks:2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
- The five-year rule, under which the entire contract value must be out within five years of the owner’s death if payments had not yet begun.
- Life expectancy payouts, under which a designated beneficiary spreads distributions over their own life expectancy, as long as payments begin within one year of the owner’s death.
- Spousal continuation, under which a surviving spouse who is the designated beneficiary steps into the owner’s shoes and treats the contract as their own, preserving deferral until they take distributions or die.
The choice matters. A lump-sum payout of $200,000 in gains can push a beneficiary into the top bracket for one year and pull in the 3.8% surtax; stretching payments over life expectancy keeps each year’s taxable slice smaller.
Situations That Change or Break the Tax Treatment
A few boundaries are worth knowing because they aren’t obvious from the general rule.
A direct insurer-to-insurer transfer from one nonqualified annuity to another is a Section 1035 exchange and produces no taxable event; your original basis carries over to the new contract.7Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies Cashing out and rebuying is not the same thing and does trigger tax.
Gifting an annuity during your lifetime is not tax-free. The IRS treats the transfer as a deemed distribution, so the donor owes ordinary income tax on all accumulated earnings as if they had cashed the contract out, and the 10% early-withdrawal penalty applies if the donor is under 59½. Gift tax rules also apply on top of the income tax, with the 2026 annual exclusion at $19,000 per recipient ($38,000 for married couples who split gifts).8Internal Revenue Service. Frequently Asked Questions on Gift Taxes
Deferral only applies when the contract is held by a natural person. If a corporation, partnership, or other non-natural entity owns the annuity and doesn’t hold it as an agent for a human, the contract loses annuity tax treatment and the annual increase in contract value is taxed as ordinary income every year, whether or not anything is withdrawn.2Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Trusts sit in a gray area: a revocable grantor trust generally preserves deferral; an irrevocable trust may or may not, depending on whether it holds the contract for an identifiable natural person. Getting the titling right at purchase matters, because restructuring ownership afterward can itself trigger tax.