What Is a Nonqualified Annuity? Withdrawals, Payouts, and Death Rules

A nonqualified annuity is funded with after-tax dollars, grows tax-deferred inside the insurance contract, and is taxed as ordinary income on the earnings when money comes out. The nonqualified annuity tax rules turn on when you take a distribution, how you take it, and who receives it: withdrawals before you annuitize are treated as earnings first, scheduled payments after annuitization are split between tax-free basis and taxable income, and transfers or death trigger their own set of rules. There are no annual contribution limits, but there is no step-up in basis at death and no capital gains rate on the growth.

How Withdrawals Are Taxed Before You Annuitize

If you pull money out of a deferred annuity before formally electing to annuitize, the IRS treats the withdrawal as coming from earnings first. Under Section 72(e), any amount you receive before the annuity starting date is allocated to income to the extent the contract’s cash value exceeds your investment in the contract.¹ You can’t touch your original principal tax-free until every dollar of accumulated earnings has come out.

An example makes the effect clear. Say your annuity has a cash value of $150,000, you contributed $100,000, and you withdraw $30,000. The entire $30,000 is taxable, because you have $50,000 of gain in the contract and the withdrawal is smaller than that. Every penny is added to your ordinary income for the year.

The 10% Early Withdrawal Penalty

On top of ordinary income tax, Section 72(q) imposes an additional 10% tax on the taxable portion of any withdrawal taken before age 59½.¹ Using the numbers above, a $30,000 withdrawal by someone under 59½ would carry an extra $3,000 penalty. The penalty only applies to earnings, not to any return of principal.

The 10% additional tax is waived in several situations:

You are 59½ or older when the distribution is made.
The contract holder has died and the distribution goes to a beneficiary.
You are disabled as defined under the tax code.
The distribution is part of a series of substantially equal periodic payments calculated over your life expectancy, or the joint life expectancies of you and a beneficiary, taken at least annually. Modify the schedule too early and the IRS retroactively applies the penalty to all prior distributions.
The payments come from an immediate annuity contract.

Section 72(q) is the penalty provision for nonqualified annuities specifically. Early withdrawal penalties for IRAs and 401(k)s fall under Section 72(t), which has a different set of exceptions. The two get confused, so confirm which section applies to your contract before relying on any exception.¹

How Payments Are Taxed Once You Annuitize

The math changes when you irrevocably elect to annuitize and start receiving scheduled payments. Instead of the earnings-first approach, the IRS splits each payment into two pieces: a tax-free return of your investment and taxable earnings. The tool for that split is the exclusion ratio.

The exclusion ratio equals your investment in the contract divided by the expected total return under the payment schedule.² For a lifetime annuity, the expected return is calculated using actuarial life expectancy tables.

In practice: you invested $200,000 and the expected total return is $400,000. Your exclusion ratio is 50%. On a $2,000 monthly payment, $1,000 is a tax-free return of principal and $1,000 is taxable ordinary income. The insurance company reports the split each year on Form 1099-R.³

The tax-free portion has an expiration date. Once you have recovered your entire investment in the contract, the exclusion ratio drops to zero and all subsequent payments are fully taxable. If you outlive your actuarial life expectancy, later payments become 100% ordinary income.¹

If you die before recovering your full cost basis, the unrecovered amount is allowed as a deduction on your final income tax return. It is treated as a business-related loss for net operating loss purposes.¹

Why Ordinary Income Treatment Matters

Every dollar of earnings that eventually comes out of a nonqualified annuity is taxed as ordinary income. The same investments held in a taxable brokerage account would generally produce long-term capital gains, which top out at 20% for most taxpayers, compared with a 37% ceiling on ordinary income. Deferral has to overcome that rate gap to pay off.

For someone in a high bracket during working years who drops meaningfully in retirement, the math can work. For someone whose bracket stays similar, internal annuity fees combined with ordinary income treatment often eat into or erase the compounding benefit of deferral.

There is a second cost at death. Investments in a taxable brokerage account get a step-up in cost basis when the owner dies, wiping out unrealized gains for heirs. Nonqualified annuities do not. Beneficiaries inherit your original cost basis and owe ordinary income tax on every dollar of accumulated earnings when they take distributions. On a large contract with decades of growth, that difference can cost heirs tens of thousands of dollars compared with inherited stocks or mutual funds.

1035 Exchanges and Lifetime Transfers

You can move money from one nonqualified annuity to another, or from a life insurance policy into an annuity, without triggering tax on accumulated earnings. This is a 1035 exchange, named for the Internal Revenue Code section that authorizes it.⁴ The transfer has to move directly between insurance companies; if you take the cash and then buy a new contract, any gains are taxable.

Partial exchanges are also allowed. Under Revenue Procedure 2011-38, a transfer of part of one annuity into a new contract is tax-free as long as no distribution (other than annuity payments over 10 years or more, or over one or more lives) is taken from either contract within 180 days of the transfer.⁵ One limit worth noting: 1035 exchanges only move sideways or down the insurance product hierarchy. A life insurance policy can be exchanged for an annuity, but an annuity cannot be exchanged for a life insurance policy.

Giving an annuity to someone else during your lifetime is a different story. Under Section 72(e)(4)(C), transferring ownership without receiving full value in return is treated as if you had received a distribution equal to the contract’s accumulated earnings, and you owe ordinary income tax on that amount in the year of the transfer.¹

There is one exception. Transfers between spouses, or between former spouses as part of a divorce settlement, are not treated as taxable distributions. The receiving spouse takes over the same cost basis. Outside that spousal exception, gifting a nonqualified annuity is one of the more expensive mistakes people make with these contracts.

Tax Rules at the Owner’s Death

When a nonqualified annuity owner dies, the tax code requires that the remaining contract value be distributed rather than held indefinitely. The timeline depends on whether the owner had already started receiving payments and on who inherits.¹

Non-Spouse Beneficiaries

If the owner dies before annuitization, the entire interest in the contract must be distributed within five years. A designated beneficiary can avoid the five-year deadline by electing to take distributions over their own life expectancy, provided payments begin within one year of the owner’s death. Either way, the original principal comes back tax-free, and all accumulated earnings are taxed as ordinary income to the beneficiary when distributed.

If the owner had already annuitized, the remaining interest must be distributed at least as rapidly as under the method already in use at the time of death.

Surviving Spouse Beneficiaries

A surviving spouse has an option no other beneficiary receives: assume ownership of the annuity entirely. Sometimes called spousal continuation, this treats the contract as if the spouse had been the original owner all along, with no immediate tax consequences and continued tax-deferred growth. For married couples using nonqualified annuities as part of a retirement plan, that continuation preserves deferral across both lifetimes.

No Step-Up in Basis

Nonqualified annuities do not receive a step-up in cost basis when the owner dies. Beneficiaries inherit the original cost basis. If the contract holds $200,000 in gains, those gains stay taxable to whoever receives them. Had the same $200,000 of growth occurred inside a taxable brokerage account, a step-up at death could have eliminated the capital gains tax entirely. It is the largest estate planning drawback of these contracts and the reason some planners suggest drawing down annuity balances during your lifetime while leaving step-up-eligible assets to heirs.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
eCFR. 26 CFR 1.72-4 – Exclusion Ratio
3
Internal Revenue Service. About Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
4
Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies
5
Internal Revenue Service. RP-2011-38 – Partial Exchange of Annuity Contracts