How Annuity Distributions Are Taxed

Understanding how annuity distributions are taxed depends on whether you bought the annuity with pre-tax or after-tax money, and the IRS uses a straightforward formula—the exclusion ratio—to split each payment between your own contributions (returned tax-free) and the earnings on those contributions (taxed as ordinary income).

The exclusion-ratio math

The IRS taxes most annuities using the exclusion ratio, a simple fraction that you calculate once when distributions start. The numerator is your cost basis—the total premiums you paid into the annuity with after-tax dollars. The denominator is your expected total return, which is the total of all payments you’re projected to receive over your life expectancy (based on IRS mortality tables).

Multiply your monthly or annual distribution by this ratio, and that portion is tax-free. The remainder is taxable ordinary income. Once you’ve recovered your entire cost basis, all further distributions become fully taxable.

Example calculation

Suppose you paid $100,000 into a non-qualified fixed annuity at age 65. The insurance company calculates that based on IRS life-expectancy tables for your age and gender, you’ll receive approximately $400,000 in total payments over your lifetime. Your exclusion ratio is $100,000 ÷ $400,000 = 0.25, or 25%.

If your first annual payment is $20,000, then $5,000 (25%) is tax-free return of your premium, and $15,000 (75%) is taxable as ordinary income. This ratio stays constant each year until you’ve recovered your full $100,000 basis.

Qualified vs. non-qualified annuities

The source of the money used to buy the annuity determines how much is taxable immediately.

Non-qualified annuities are purchased with after-tax dollars—money left over after you’ve paid income tax. Only the earnings component is taxable each year. Your cost basis (what you paid) flows through tax-free. This is where the exclusion ratio applies and is most recognizable.

Qualified annuities are bought with pre-tax money, typically inside a traditional IRA, 401(k), or 403(b) plan. Since the entire account is pre-tax, there is no cost basis to recover; you have no exclusion ratio. Every single dollar you receive—including a return of your contributions—is taxable ordinary income, because the original contribution was deducted on your tax return.

The final reckoning

Once you’ve received distributions totaling your cost basis, the exclusion ratio expires. All subsequent payments become 100% taxable. For example, if you recover your $100,000 cost basis after receiving 20 years of payments, every distribution in year 21 onward is fully taxable.

This assumes you live as long as the IRS mortality tables predict. If you die before recovering your full basis, the unrecovered amount is deductible on your final income tax return (or your estate’s return, depending on how it’s structured). If you outlive the mortality assumption and receive more than expected, you don’t get a tax break—the excess is simply taxable.

Fixed vs. variable annuities

The taxation method doesn’t change, but the income amount varies. A fixed annuity pays the same amount each month for life, so the exclusion ratio stays mathematically simple—same dollar amount tax-free every period. A variable annuity pays an amount tied to the underlying investment performance, so the dollar amount fluctuates. The IRS still requires you to use the original exclusion ratio percentage on whatever amount you receive, making the tax-free dollar amount bounce around each period.

Inherited annuities and stretch rules

If you inherit an annuity, the taxation still hinges on the original account holder’s cost basis. Under current law (post-SECURE Act), most non-spouse beneficiaries must empty inherited qualified annuities within 10 years, which can trigger large taxable distributions in the final year. The exclusion ratio, if one applies, moves with the annuity to the beneficiary and continues to reduce the taxable portion—at least until the basis is recovered.

A surviving spouse can treat the inherited annuity as their own, preserving the original exclusion ratio and deferring distributions until their own required age. Other beneficiaries do not have that option and face compressed distribution schedules.

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