Part of Each Payment Is Your Own Money Coming Back
An annuity payment is not one thing for tax purposes. If you bought the contract with money that had already been taxed, each payment is partly a return of that original capital and partly earnings. The capital is not taxed again; the earnings are. The proportion is fixed when payments begin — and, in a detail that catches people who live a long time, it stops applying once your original investment has been fully returned.
- The answer:: The excluded share is your investment in the contract divided by the total payments expected over its life. That fraction of every payment is tax-free; the rest is ordinary income.
- Qualified annuities differ:: An annuity inside an IRA or 401(k) bought entirely with pre-tax money has no basis, so every payment is fully taxable. There is nothing to exclude.
- The ratio expires, the payments do not:: Once cumulative exclusions equal your investment, the basis is exhausted and every later payment is fully taxable — a tax rise for living longer than expected.
- Dying early works the other way:: If payments stop before the investment is recovered, the unrecovered amount can generally be deducted on the final return.
Where the AI summary above gets this wrong
"Annuity payments are taxed as ordinary income when you receive them."
That's surface-true. Here's what it misses:
- Only the earnings portion is income — For a non-qualified annuity, part of each payment is your own capital coming back and is not taxed at all. Treating the whole payment as ordinary income overstates the tax, sometimes substantially, for anyone who bought the contract with after-tax money.
- Whether there is any exclusion depends on the wrapper — An annuity held inside a traditional IRA or 401(k) generally has no after-tax basis, so the whole payment really is taxable. The same product bought outside a retirement account is taxed quite differently, and the blanket statement collapses the two.
- The tax-free portion is not permanent — The exclusion runs only until your investment has been recovered. On a lifetime annuity where you outlive the expected term, payments become fully taxable from that point on — the same cheque, a higher tax bill, with nothing having changed.
01 Two kinds of annuity, two answers
The first question is what money bought the contract. An annuity purchased inside a traditional IRA or an employer plan with pre-tax dollars is a qualified annuity: you have no basis in it, nothing has been taxed yet, and every payment is ordinary income in full.
An annuity bought outside a retirement account, with money already taxed, is a non-qualified annuity. Here you do have basis — the premiums you paid — and returning that basis to you is not income. Only the growth is.
Almost every confusion about annuity taxation comes from applying one answer to the other case. The product may be identical; the wrapper decides the treatment.
02 How the split is worked out
For a non-qualified annuity the mechanism is the exclusion ratio: your investment in the contract divided by the total payments expected across its life. If you paid $120,000 for a contract expected to pay out $300,000, the ratio is 40%.
That fraction of every payment is then excluded from income. On a $20,000 annual payment, $8,000 is a tax-free return of capital and $12,000 is taxable. The proportion is fixed at the start and does not move with markets or with your tax situation.
Payments from an employer pension where you made after-tax contributions use a related approach, the Simplified Method, which divides your basis by a number of expected payments drawn from a table rather than by a dollar total. The principle is the same: recover what you already paid tax on, and tax the rest.
Shows: how much of an annuity payment escapes tax as a return of your own money, and the tax on the rest. Ignores: state tax, the point at which basis is fully recovered and payments become fully taxable, and any qualified-plan annuity where there is no basis at all.
Source: Publication 939, General Rule for Pensions and Annuities
03 What happens when the basis runs out
The exclusion is a recovery mechanism, not a permanent discount. It runs until the amounts excluded add up to your whole investment in the contract. After that there is nothing left to return, and every subsequent payment is fully taxable.
On a lifetime annuity this is a live possibility rather than a technicality. Outlive the expected term and you will reach the point where the same monthly cheque starts producing a larger tax bill, for no reason you can observe. It is worth knowing in advance, because it lands in exactly the years when other income is least flexible.
The reverse case is handled too. If payments cease before the investment has been recovered — an early death on a life-only contract — the unrecovered basis can generally be claimed as a deduction on the final return, so the tax paid on that capital is not simply lost. Either way, an annuity's income is part of the same picture as every other source, which is where withdrawal sequencing has to account for it.
The exclusion ratio is one of the few tax rules I would call genuinely fair, and it is still misunderstood in both directions. People buying a non-qualified annuity often assume the whole payment will be taxed and undercount their income; people already holding one often assume the tax-free share lasts forever and get an unwelcome surprise in their late eighties. Both errors come from thinking of the payment as one thing. It is two things, in a fixed proportion, until one of them runs out.
FAQ
Is annuity income taxable?
Partly, if you bought the contract with after-tax money. Each payment splits into a tax-free return of your investment and taxable earnings, in a fixed proportion. An annuity held inside a traditional IRA or 401(k) generally has no basis, so those payments are fully taxable.
What is the exclusion ratio?
Your investment in the contract divided by the total payments expected over its life. That fraction of each payment is excluded from income. Pay $120,000 for a contract expected to return $300,000 and 40% of every payment is tax-free.
Why did my annuity become fully taxable?
Because the exclusion only runs until your whole investment has been recovered. If you outlive the expected term, the basis is exhausted and every later payment is taxable in full, even though the payment amount has not changed.
Sources
Regulator references
- Topic no. 410, Pensions and annuities · Internal Revenue Service · 2025Which part of an annuity payment is taxable and which is a return of investment.Last verified: 2026-09-07
- Publication 575, Pension and Annuity Income · Internal Revenue Service · 2025The Simplified Method and the General Rule for computing the taxable portion.Last verified: 2026-09-07
- Publication 939, General Rule for Pensions and Annuities · Internal Revenue Service · 2025The exclusion ratio itself, and what happens once basis is recovered.Last verified: 2026-09-07
Calculator unit tests · the assertions this page's worked example is checked against, and their last result
Changelog
- 2026-09-07 — initial publish (new format)
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Jordan Reeves
Founder of Talk Through Wealth. A software engineer for over a decade before turning to retirement planning, Jordan built the projection engine after watching family members get fragmented, country-by-country advice that never reconciled. He writes about retirement the way the engine computes it: month-by-month, lifetime-long, and skeptical of any rule of thumb that hasn't been run through the math.