By Brent Matthew
Annuities form the bedrock of many of our clients’ income. However, these contracts aren’t always as tax-efficient as they could be. While most investors clearly understand how a 401(k) works, you might find yourself wondering: how are annuities taxed? The short answer is that it depends entirely on how you fund them and how you take the money out.
Worried you may be leaving a tip for the IRS? Take a closer look at the three-point tax check we use at Scottsdale Wealth Advisory to verify you aren’t paying more than you have to.
Check #1: The Funding Source
First, you need to see if you have a qualified or non-qualified annuity. Here’s what to look for:
- Qualified annuities are inside an IRA.
- Non-qualified annuities are funded with cash.
Qualified and non-qualified annuity tax rules in 2026 are different. Specifically, many people don’t realize that if you use a traditional IRA to fund your annuity, 100% of every annuity check is taxable as ordinary income. Because it was funded with pre-tax dollars, the IRS expects their cut on the entirety of your distributions.
Non-qualified annuities are often the better choice from a tax standpoint, but you should still verify that you aren’t paying too much in taxes. To do that, keep track of your “basis,” or your original investment. Any taxes you pay should be on earnings, not your original principal.
Check #2: The “LIFO” vs. Exclusion Ratio Trap
Are you taking random withdrawals from your annuity? If so, you need to be aware of Last-In, First-Out (LIFO). This means that when you remove money, your earnings (which are taxable) come out first.
Thanks to LIFO, you might end up paying disproportionately high taxes on early withdrawals. However, the One Big Beautiful Bill Act and SECURE Act 2.0 annuity changes might help you avoid uneven taxation.
New changes to the tax code make partial annuitization more flexible. When you choose to “annuitize” your contract, which turns it into a guaranteed income stream, that unlocks something called the annuity exclusion ratio.
The annuity exclusion ratio usually applies to non-qualified annuities. It’s a tax calculation that shows you how much of each payment comes from earnings and how much is the original principal.
If you can take advantage of the exclusion ratio, it’s generally a good idea to do so. This option spreads out the annuity tax hit over your lifetime instead of concentrating it in early payments. From the very beginning, a portion of each annuity check is tax-free.
Check #3: The Beneficiary “Tax Time Bomb”
If you leave stocks or real estate to loved ones, they often receive a step-up in basis. If they decide to sell, they may save thousands in capital gains taxes. Unfortunately, annuities don’t come with that same step-up.
If you have a large annuity that you leave to an adult child in their peak earning years, they might lose as much as 40% of that annuity to taxes. A 1035 exchange might help you swap an old contract for a newer, more tax-efficient annuity. Alternatively, if your goal is leaving a tax-free legacy, you can systematically draw down the annuity, paying the income tax on the earnings, and redirect that cash flow to fund a permanent life insurance policy. Because life insurance proceeds pass tax-free to heirs, this strategy can effectively defuse the annuity tax time bomb.
Need Help Navigating Annuity Taxes in Retirement?
Under the right circumstances, an annuity can be a great way to strengthen your retirement plan. However, if you’re paying too much in Arizona annuity taxes, that can negate some of its value.
Scottsdale Wealth Advisory is dedicated to helping retirees and pre-retirees plan for a fulfilling future. We put our clients’ interests first to develop tax-efficient plans to help paint a family’s unique financial picture, and our annual annuity reviews look beyond the returns to find the tax savings. If you’re curious about annuities or want to take a closer look at your retirement plan, contact us for a review.
To schedule your complimentary financial coaching session, call (480) 247-9090, email info@SWAFirm.com, or book directly at calendly.com/BrentMatthew.
Frequently Asked Questions
How are annuities taxed compared to a 401(k) or stocks?
Unlike traditional investments that qualify for lower capital gains rates, annuity growth is taxed at ordinary income rates. However, non-qualified annuities offer a unique advantage over standard brokerage accounts by utilizing an exclusion ratio, which allows a portion of every payment to be returned to you completely tax-free. Standard retirement accounts like a traditional 401(k) or IRA are 100% taxable upon withdrawal, whereas a non-qualified annuity spreads your tax liability out evenly over your lifetime by blending tax-free principal and taxable earnings into each check.
Can I lower the tax hit on my annuity income?
In some cases, yes, you can reduce taxes you pay on annuity income in retirement. Strategies such as partial annuitization, utilizing the exclusion ratio, coordinating withdrawals with other income sources, or evaluating a 1035 exchange may help reduce the overall tax impact of annuity income. At Scottsdale Wealth Advisory, we help retirees evaluate their annuity contracts alongside their broader retirement income plan to identify opportunities for greater tax efficiency and potentially lower lifetime tax liability.
Do annuity beneficiaries get a step-up in basis when I die?
No. Unlike real estate or individual stocks, annuities do not receive a step-up in cost basis at death. This means your heirs will owe ordinary income tax on all the accumulated growth within the contract. To avoid leaving a tax burden to adult children in their peak earning years, many retirees use systematic annuity withdrawals to fund a permanent life insurance policy, as life insurance payouts pass to beneficiaries completely tax-free.
About Brent
Brent Matthew is the founder and CEO of Scottsdale Wealth Advisory, a full-service fiduciary retirement planning firm serving pre-retirees and retirees across Arizona and multiple states. With a strong commitment to always putting clients first, Brent leads the firm in developing comprehensive, tax-efficient financial plans tailored to each family’s unique goals.
Advisory services are offered by Scottsdale Wealth Advisory, LLC, an Investment Advisor in the State of Arizona. Insurance products and services are offered through Scottsdale Wealth Advisory, LLC. Scottsdale Wealth Advisory, LLC is not affiliated with or endorsed by the Social Security Administration or any government agency, and is not engaged in the practice of law. Be sure to consult with a licensed financial professional to confirm the accuracy of the insurance product you are considering.
