Annuities are taxed as ordinary income, but how much depends on funding: Qualified (pre-tax money like 401k/IRA) means the whole payment is taxed; Nonqualified (after-tax money) means earnings are taxed first, then principal, often using LIFO (Last-In, First-Out) for withdrawals before annuitization. Withdrawals before 59½ usually face a 10% penalty on earnings, with exceptions like disability or specific expenses.
“The gains generated in an annuity are taxed as ordinary income. So, gains in a nonqualified deferred annuity are taxed just like money in your pretax 401(k).” A 10-percent penalty tax generally applies to the taxable amount of withdrawals from nonqualified deferred annuities made before the owner attains age 59½.
Federal taxes on annuities are paid at your ordinary income tax rate, as earnings grow tax-deferred until withdrawal, with a 10% penalty for early withdrawals before age 59½ (unless exceptions apply) and potential Net Investment Income Tax (NIIT) if your income is high enough. Withdrawals are taxed as "last-in, first-out" (LIFO), meaning earnings come out first and are taxed, while contributions (principal) are tax-free until all earnings are withdrawn.
The "annuity 5-year rule" generally refers to the IRS requirement for non-spouse beneficiaries to withdraw the entire balance of an inherited nonqualified annuity by the end of the fifth year after the original owner's death, offering tax flexibility to spread out income. While you can take distributions anytime within that 5-year window, the full amount must be gone by the deadline, or penalties/taxes can apply. Spouses have more options, like becoming the new owner, while the 10-year rule (from the SECURE Act) now applies to many "eligible designated beneficiaries," but the 5-year rule still governs older contracts or specific situations.
To get $1,000 a month from an annuity, you'll generally need a lump sum investment, with estimates often falling in the $185,000 to $200,000+ range for a lifetime payout, but the exact cost depends heavily on your age, gender, chosen payout option (like lifetime vs. period certain), current interest rates, and the insurance company's products, with older ages and simpler options typically requiring less capital for the same income.
Immediate annuities might be an option if you want an instant source of income during retirement. However, payments start right away, so there isn't much time for interest to build up. For a 65-year-old retired male, a $300,000 immediate lifetime annuity would pay between $1,800 and $2,000 monthly.
Generally, pension and annuity payments are subject to Federal income tax withholding. The withholding rules apply to the taxable part of payments or distributions from an employer pension, annuity, profit-sharing, stock bonus, or other deferred compensation plan.
People who turned 65 by Dec. 31, 2025, are eligible for the new deduction, according to the IRS. The deduction provides $6,000 for each qualifying individual, or $12,000 for married couples who both qualify. The tax break is subject to income limits.
To avoid the 22% tax bracket (or any higher bracket), focus on reducing your taxable income through strategies like maxing out 401(k)s and HSAs, deferring bonuses, tax-loss harvesting, smart charitable giving, and strategic asset location, understanding that higher rates only apply to income within that bracket, not your entire income.
Roth Accounts. Some annuities can also be set up as a Roth account, similar to Roth IRAs. Since the annuity would have been funded with after-tax money, you would not owe taxes on this when withdrawn. Since it is classified as a Roth, you can also potentially make tax-free withdrawals of the growth from your account.
Pension payments, annuities, and the interest or dividends from your savings and investments are not earnings for Social Security purposes. You may need to pay income tax, but you do not pay Social Security taxes.
Whether a 401(k), IRA, personal portfolio, or a mix of strategies is better than an annuity depends on your financial goals, risk tolerance and income needs. Most retirees will benefit from a diversified approach that combines different income sources for flexibility and security.
With annuities, you transfer the risk to the life insurance company that issues the product. You are transferring the risk for the primary four things that make up my acronym PILL, which I created and trademarked. Those are the four reasons annuities exist.
Are you curious about fixed index annuities and wondering why **Dave Ramsey doesn't recommend them**? You're not alone. These financial products can offer retirement income with market-linked growth and principal protection—but they're also misunderstood.
However, their drawbacks include overwhelming complexity, fees, lack of liquidity and tax penalties for early withdrawals. You should carefully evaluate your individual financial situation and consult a fee-only financial planner to determine if an annuity is the right investment for you.
So, many wealthy people use annuities to protect themselves in our litigious world, but they also buy them for lifetime income streams. Many rich people buy annuities for their spouses, kids, or grandkids.