If you’re thinking about purchasing an annuity, one of the first questions you probably have is: “How will this be taxed?”
Great question — because depending on how you fund your annuity, your taxes can be very little… or quite a lot… or sometimes none at all.
In this guide, I’ll walk you through exactly how annuity taxation works, how income is treated under different funding types, what the exclusion ratio means, and whether there are legitimate ways to reduce or manage taxes in retirement.
Need help choosing the best annuity for your unique situation? Have questions about getting an annuity? If so, it’s best to speak with an annuity specialist. Watch this short video to see how I can help you do this (at no cost to you!)
Tip: See how much an annuity could pay you using our annuity calculator.
How Annuity Income Is Taxed Depends on Your Funding Source
The same annuity can be taxed very differently depending on the bucket of money you use.
Here are the three main categories:
Non-Qualified (Cash / Taxable Assets)
- Funded with after-tax dollars
- Your tax basis has already been taxed
- Only the earnings portion of each payment is taxable
- Part of your income can be tax-free
Traditional IRA, 401(k), TSP, 403(b)
- Funded with pre-tax dollars
- 100% of income is taxed as ordinary income
- No special tax treatment — every payment is taxable
Roth IRA
- Funded with post-tax dollars
- Zero taxes forever, as long as rules are met
- Income from a Roth-funded annuity is completely tax-free
👉 Pro Tip: A Roth annuity is the only way to receive guaranteed lifetime income that is tax-free for life. Not all carriers allow Roth conversions after purchase, so get guidance before choosing a contract.
How Taxes Work With a Non-Qualified Annuity (LIFO Method)
Let’s use a real example:
A 67-year-old puts $500,000 cash into an income annuity with an income rider.
He defers for 3 years and begins lifetime income at age 70.
The payout is $51,000 per year, guaranteed for life.
Here’s how the taxes shake out:
Years 1–X: Partial Taxation
Because this is a non-qualified annuity, the IRS uses LIFO (Last In, First Out) rules:
- The “last in” is interest/earnings, so those are paid out — and taxed — first.
- The rest of the withdrawal is tax-free return of premium.
Example:
- Annual income: $51,000
- Taxable portion (earnings): maybe $10,000
- Tax-free portion: $41,000
Each year the taxable portion changes based on how much the account earns.
When You Get All Your Money Back
Once the insurer has returned your entire original $500,000 (through the tax-free portion of payments), the rest of your lifetime income becomes fully taxable — because at that point, it’s all earnings.
This is the trade-off:
✔ Lower taxes early on
✔ Higher taxes once your basis has been fully recovered
✔ Lifetime income no matter what
👉 Want help structuring an annuity for lower taxable income early in retirement? Click here to schedule a call.
How Taxes Work With a Traditional IRA Annuity
This one is simple:
Every dollar is taxed as ordinary income.
- $51,000 income = $51,000 taxable
- No exclusion ratio
- No tax-free portion
And unlike normal IRA withdrawals, annuity payments continue even after your IRA runs dry — but they remain taxable because they’re tied to the tax status of the IRA.
RMD Benefits
If your annuity is inside an IRA:
- Income typically satisfies your Required Minimum Distributions
- Sometimes it can even satisfy RMDs across multiple IRAs depending on the carrier
This is one of the biggest tax-management perks for retirees using annuities.
How Taxes Work With a Roth IRA Annuity
This is the easiest scenario:
All income is 100% tax-free for life.
BUT — not all carriers allow Roth conversions after the annuity is purchased.
A few that do:
- American Equity
- Midland
- Nationwide (full conversion only)
Most high-income options do not allow conversions, so tax planning matters.
👉 Pro Tip: If you’re considering a Roth conversion, do the math before buying the annuity — the tax bill upfront can be painful, and break-even ages often fall in your 80s.
SPIAs and DIAs: How the Exclusion Ratio Reduces Taxes
Single Premium Immediate Annuities (SPIAs) and Deferred Income Annuities (DIAs) are taxed differently when funded with cash.
They use something called the exclusion ratio.
What is the exclusion ratio?
The insurer estimates:
- Your life expectancy
- How much of each payment is “return of premium”
- How much is “earnings”
And then they lock in a fixed taxable amount each year.
Example:
$500,000 into a SPIA gives:
- Monthly income: $3,084.63
- Tax-free portion: ~$2,000 per month
- Taxable portion: ~$1,000 per month
That taxable portion remains the same every year .
👉 Want me to run exclusion ratio numbers for your exact age and funding amount? Schedule a call here.
Is There a Way to Reduce Taxes on Annuity Income?
Yes — several.
Strategy 1: Use Non-Qualified Money First
This gives you:
- Lower taxes in early retirement
- Large tax-free portions of each payment
- More control of your taxable income
Strategy 2: Use an Income Rider Instead of Annuitization
Income riders:
- Allow tax-free return of premium
- Are more flexible
- Often produce higher lifetime income
- May be better for tax management vs. SPIA/DIA
Strategy 3: Spread Out Roth Conversions
Small conversions over multiple years:
- Keep taxes lower
- Prevent bracket jumps
- Allow you to build tax-free income buckets
Strategy 4: Let Annuity Income Satisfy RMDs
This avoids being forced to sell market assets at a bad time.
Strategy 5: Pair Annuities With Tax-Efficient Investments
Many retirees blend:
- A non-qualified annuity for tax-managed income
- A Roth for tax-free income
- A traditional IRA for RMDs only
👉 Want a custom tax strategy built around your income goals? Book a consultation here.
Conclusion
Annuity taxation isn’t complicated once you understand the rules.
What matters most is choosing the right funding source and the right contract type for your retirement goals.
When done correctly, annuities can:
- Reduce taxable income early in retirement
- Satisfy RMDs automatically
- Create tax-free lifetime income (with a Roth)
- Give you predictable, guaranteed income for life
Need help with finding the best annuity for your retirement?
Click here to schedule a call with me.
On the call, I can help you:
- Determine what type of annuity is best for you
- Find the highest paying annuities for your unique situation
- Answer any other questions you may have