Partial Annuitization: Exclusion Ratio, Penalties, and NIIT

Under partial annuitization tax rules, a single deferred annuity contract is split into two pieces that are taxed on completely different tracks. The annuitized portion pays out under the Section 72 exclusion ratio, so each payment is part tax-free return of basis and part taxable earnings. The retained accumulation portion follows the far less favorable earnings-first rule: any withdrawal is fully taxable as ordinary income until every dollar of gain in that portion has come out. Layered on top are a possible 10% early-distribution penalty, the 3.8% Net Investment Income Tax, and Medicare premium surcharges triggered by the added income.

How the Contract Splits Into Two Tax Tracks

When you partially annuitize, the insurer carves your contract in two. One piece becomes a guaranteed income stream (life, period certain, joint and survivor, or some combination). The other piece stays in the accumulation phase and continues to grow tax-deferred. Your original investment in the contract, meaning the after-tax premiums you paid in, is allocated between the two pieces in proportion to the split. That allocation is permanent. You cannot later claim the retained portion’s basis against the annuitized income, or the other way around.

The reason this matters for taxes is that each side is governed by a different subsection of Internal Revenue Code Section 72, and the results diverge sharply.

Tax on the Annuitized Portion: The Exclusion Ratio

For non-qualified annuities funded with after-tax dollars, each annuity payment is taxed under IRC Section 72(b). The statute provides that gross income does not include the portion of each payment that bears the same ratio to the total payment as your investment in the contract bears to the expected return under the contract.¹

The mechanics of a partial election. Say your total basis is $200,000 on a $400,000 contract and you annuitize $100,000 of it. That’s 25% of the contract, so 25% of your basis, or $50,000, moves to the income stream. If the insurer calculates an expected return of $150,000 on the annuitized portion, your exclusion ratio is $50,000 ÷ $150,000, or 33.3%. Roughly a third of each payment comes back tax-free; the rest is taxable as ordinary income.

The exclusion is capped at your unrecovered investment in the contract immediately before each payment. Once you’ve recovered the full $50,000 of allocated basis, every subsequent payment is 100% taxable as ordinary income. The insurer reports the taxable and non-taxable portions of your payments on Form 1099-R each year.²

Tax on the Retained Portion: Earnings First

The retained accumulation portion is governed by IRC Section 72(e), and the rule is much harsher. Any withdrawal taken before the annuity starting date is treated as earnings first, taxable as ordinary income, until every dollar of gain in the contract has been distributed. Only after all the earnings have come out do further withdrawals become a tax-free return of basis.¹

The statutory math: a withdrawal is allocable to income to the extent it doesn’t exceed the excess of the contract’s cash value (ignoring surrender charges) over the investment in the contract at that time. Anything beyond that is allocable to basis. There is no exclusion ratio benefit on the retained side. Early withdrawals hit at your full ordinary income tax rate.

That asymmetry drives most of the planning tension around partial annuitization. The annuitized portion blends taxable and tax-free money in every check. The retained portion forces all the gain out first if you touch it. How much you annuitize versus how much you retain shapes your tax bill for years.

Qualified Annuities: No Exclusion Ratio

If the annuity sits inside a traditional IRA, 403(b), or similar qualified plan, the tax picture simplifies. There’s no exclusion ratio and no basis allocation, because the contributions went in pre-tax. Every payment from the annuitized portion and every withdrawal from the retained portion is fully taxable as ordinary income. The only exception is any non-deductible contributions in the account, which keep their basis.

Qualified annuities also interact with required minimum distributions. Under SECURE 2.0, RMDs begin at age 73, or age 75 if you were born in 1960 or later. Annuity payments from the annuitized portion generally count toward the RMD for that account. The IRS has delayed final regulations on exactly how partial annuitization satisfies RMD requirements until at least January 1, 2027; until then, plan administrators and owners are expected to follow a reasonable, good-faith interpretation of the statute.

The 10% Early Distribution Penalty

Withdrawals from the retained portion taken before age 59½ are subject to a 10% additional tax on the taxable amount under IRC Section 72(q). This is separate from the Section 72(t) penalty that applies to qualified plans, though the effect is similar.¹

Several exceptions apply. Distributions made after the holder’s death, those attributable to disability, and payments structured as substantially equal periodic payments over your life expectancy all qualify. Payments received under an immediate annuity contract are also exempt, which means the annuitized portion of a partial annuitization generally avoids the penalty even if you’re under 59½.¹

The 3.8% Net Investment Income Tax

The taxable portion of non-qualified annuity income counts as net investment income under IRC Section 1411. If your modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly), you owe an additional 3.8% surtax on the lesser of your net investment income or the amount by which your MAGI exceeds the threshold.³ The thresholds are not indexed for inflation.

Distributions from qualified plans such as IRAs and 403(b)s are not subject to the NIIT.⁴ That distinction matters when you hold both qualified and non-qualified contracts and are deciding which one to partially annuitize. Non-qualified payments carry NIIT exposure; qualified payments don’t.

Medicare Premium Surcharges

Annuity income of any kind, whether from the annuitized stream or a withdrawal from the retained side, increases your MAGI. If that pushes you above certain thresholds, you’ll pay Income-Related Monthly Adjustment Amounts on your Medicare Part B and Part D premiums. IRMAA is based on your tax return from two years earlier, so a large annuitization event in 2026 shows up on your 2028 Medicare bill.

For 2026, the Part B IRMAA surcharges are:⁵

Single MAGI up to $109,000 (joint up to $218,000): no surcharge
$109,001–$137,000 (joint $218,001–$274,000): $81.20 per month
$137,001–$171,000 (joint $274,001–$342,000): $202.90 per month
$171,001–$205,000 (joint $342,001–$410,000): $324.60 per month
$205,001–$499,999 (joint $410,001–$749,999): $446.30 per month
$500,000 or more (joint $750,000 or more): $487.00 per month

Part D carries its own separate surcharges at the same income brackets, ranging from $14.50 to $91.00 per month. Because a partial election lets you control how much taxable income you generate in a given year, it can be calibrated to stay under a bracket that a full annuitization would clear.

Reporting and Recordkeeping

After the split, the insurer sends a confirmation document showing the basis allocated to each portion, the exclusion ratio on the annuitized segment (for non-qualified contracts), and the payment schedule. Keep it permanently. That paperwork is the foundation for every tax return filed while either portion exists, and reconstructing the numbers years later is difficult once the documentation is gone. Each year the insurer reports payments and their taxable share on Form 1099-R.²

One boundary worth flagging: these rules cover federal income tax treatment of the contract itself. If you’re considering an annuity in the context of Medicaid long-term care eligibility, separate federal requirements govern how the annuity must be structured (irrevocable, non-assignable, actuarially sound, with the state named as remainder beneficiary in the required position) and state implementation of those rules varies.⁶ Those requirements sit outside the income tax analysis above and need to be built in from the start, because an irrevocable annuity can’t be restructured after the fact.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Instructions for Forms 1099-R and 5498 (2025)
3
Office of the Law Revision Counsel. 26 U.S. Code 1411 – Imposition of Tax
4
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
5
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
6
Office of the Law Revision Counsel. 42 USC 1396p – Liens, Adjustments and Recoveries, and Transfers of Assets