How annuity growth and payouts are taxed, in plain English

An annuity is a contract with an insurance company: you pay in, and it pays you later. This is general information about a deferred annuity funded with after-tax dollars, not a suggestion to buy one. Deferred means taxed later, not never. We follow each dollar with the Top-Layer Tap Test below.

The rules at a glance

Fixed payouts are split by an exclusion ratio: what you paid in divided by the expected return, which is the yearly payment times an age multiple (16.0 at age 70, Treasury Table V). For payouts that began after 1986, every payment is fully taxable once your cost is recovered. If the annuitant dies first, the unrecovered cost is an itemized deduction on the final return.

An invented example

Maria, 52, paid $100,000 for a deferred annuity now worth $140,000. She withdraws $30,000. Gain comes first, so all $30,000 is taxable, plus a $3,000 early tax. That leaves $110,000 of value and $10,000 of gain. At 53, with the value unchanged, she takes out $25,000: $10,000 is taxable (plus $1,000 early tax) and $15,000 is a return of cost.

Annuities held in retirement accounts

An annuity held in a plan or IRA follows that account's rules and gains no extra deferral. A qualifying longevity annuity contract (QLAC) is a deferred annuity bought in such an account that must start paying by the first of the month after the 85th birthday; its value is left out of the balance used for required minimum distributions. The premium limit is $210,000 for 2025 and 2026. The IRS has not yet published a 2027 limit; it usually does so in November.

Illinois lets you subtract the taxable part of qualified plan and IRA payouts, but not non-qualified annuity income. Taxable annuity income also counts toward tax on Social Security benefits and, two years later, Medicare premium surcharges (IRMAA).

The Top-Layer Tap Test

People in this situation often consider these steps; ask your adviser.

• Total the premiums you paid, from the insurer's statement.
• Subtract that from the cash value, ignoring surrender charges, to see the gain on top.
• Before a withdrawal, ask how much is gain and whether age 59 1/2 or an exception applies.
• Ask who owns it; a company or some trusts changes the rule.

See the annuities group page, types and 1035 exchanges, cautions, fees and NIIT and Medicare and IRMAA.

Common questions

Official sources

• Internal Revenue Code section 72, annuities (Cornell Legal Information Institute)
• IRS Publication 939, General Rule for pensions and annuities
• IRS Publication 575, pension and annuity income
• Treasury Regulation 1.72-9, actuarial tables (eCFR)
• Treasury Regulation 1.401(a)(9)-6, annuity payouts and QLACs (eCFR)
• IRS Notice 2025-67 (2026 plan limits, including the QLAC limit)
• Illinois Department of Revenue: Publication 120, retirement income

Keep reading

• Annuities: how they are taxed, exchanged and weighed
• Fixed, indexed and variable annuities, and how a 1035 exchange works
• Annuity fine print: costs, limits and the surprise tax
• Medicare enrollment and IRMAA: the dates and the income test