Key Takeaways
Not all types of annuities are taxed the same. Explaining the differences to clients brings clarity and confidence.
Tax-deferred doesn’t mean tax free. It means your clients have more control over when they pay taxes.
The full picture matters. Placement in a financial plan is just as important as the product itself.
Don’t go it alone. Partnering with a tax advisor helps you serve clients more holistically and enhances client peace of mind.
Let’s be honest—taxes aren’t the part of retirement planning that clients get excited about. But when it comes to annuities, understanding how they’re taxed can be the difference between hesitation and forward motion. In my experience, most clients just want to know what they’re getting into. And they’re relying on you to help them make sense of it.
At Delaware Life, we’re here to help you simplify the conversation and connect the dots between annuity strategy and tax outcomes. Let’s walk through how to explain annuity taxation in a way that connects with clients and supports the kind of planning you’re already doing.
Starting the Conversation: From Annuity Basics to Tax Diversification
Before diving into product features or tax rules, it’s important to ground clients in what an annuity actually is and the role it can play in a broader retirement strategy. The truth is, most clients don’t really know. Annuities have been wrapped in jargon for too long. But here’s what I tell advisors: simplify it.
An annuity is a contract that turns savings into a predictable income stream—often for life.
This simple explanation helps clients connect annuities to familiar concepts like pensions or Social Security. From there, it’s easier to introduce what annuities do: manage longevity risk, reduce market exposure, and create income control through tax deferral.
Shift to Strategy: Tax Diversification and Income Control
Once the client understands what an annuity is, the next step is showing where it fits in the broader retirement plan. Just like clients diversify investments by asset class, they also need to diversify how their income is taxed in retirement.
| Tax Bucket | Examples | Use Case |
|---|---|---|
| Taxable | Brokerage, savings, CDs | Daily spending, liquidity |
| Tax-Deferred | Traditional IRAs, 401(k)s, nonqualified annuities | Income planning, deferral strategy |
| Tax-Free | Roth IRAs, HSAs | Strategic withdrawals, healthcare, big expenses |
Explaining How Annuities Are Taxed (Without Overcomplicating It)
Annuity taxation depends on two key factors: how the contract is funded and how distributions are taken.
Traditional qualified annuities: All withdrawals are taxed as ordinary income.
Non-qualified annuities: Only the earnings are taxed. The principal (basis) comes back tax-free.
Most clients won’t remember the IRS definitions—but they’ll remember how it affects their income.
| Qualified Annuity | Non-Qualified Annuity | |
|---|---|---|
| Funded With | Pre-tax dollars (e.g., IRA, 401(k)) | After-tax dollars (savings, CD, brokerage) |
| Tax Treatment | Earnings + principal taxed at withdrawal | Only earnings taxed (principal is tax-free) |
| Purpose | Retirement savings | Tax-deferred growth outside retirement plans |
| Required Distributions? | Yes (currently start at age 73) | No required distributions during lifetime |
Annuitized Income and the Exclusion Ratio
When clients annuitize—that is, turn a lump sum into guaranteed payments, typically for life—each payment includes:
A taxable portion (earnings)
A tax-free portion (return of basis)
The exclusion ratio determines how much of each payment is taxable. It’s a powerful tool for tax-efficient income.
What If Clients Don’t Annuitize?
If a client chooses not to annuitize and instead takes withdrawals, non-qualified annuities follow LIFO rules—Last In, First Out. That means earnings come out first and are taxed as ordinary income. After the gain is withdrawn, the rest (basis) is tax-free. Annuities taxed as ordinary income may result in higher or lower tax liability depending on the individual’s tax bracket.
| Distribution Type | How It's Taxed |
|---|---|
| Treated as an annuity (annuitized) | Partial tax-free (return of basis) + taxable gain |
| Not treated as an annuity | LIFO: earnings first (fully taxable), then basis |
RMDs and Early Withdrawal Rules
Qualified annuities are subject to required minimum distributions starting at age 73. Withdrawals before age 59½ may face a 10% IRS penalty—unless the client qualifies for one of the newer exceptions.
Non-qualified annuities do not have required distributions at a certain age but are subject to a 10% early distribution penalty.
These aren’t punitive rules. They’re meant to encourage long-term savings—and when clients understand that, they’re less likely to make reactive decisions based on market conditions and volatility.
Tax Deferral Can Do More Than You Think
Tax deferral often gets oversimplified. It’s not just about kicking the can down the road. In the right situation, it can help clients avoid taxes they’d otherwise pay today.
For example, gains inside a non-qualified annuity aren’t included in current income calculations. This can be a key strategy for helping clients reduce their exposure to stealth taxes like Medicare IRMAA surcharges and Net Investment Income Tax (NITT).
When gains stay inside a non-qualified annuity, they don’t count toward provisional income. That can help clients avoid taxes on Social Security, higher Medicare premiums, and even the 3.8% Net Investment Income Tax.
Capital Gains vs. Ordinary Income
Highlight to clients that it depends on when the income is taxed—not just how. Many retirees fall into the 12% tax bracket, which is lower than most capital gains rates.
| Scenario | Tax Bracket | Type of Income | Tax Rate |
|---|---|---|---|
| Retired couple with $85K income | 12% | Ordinary Income | ~12% |
| Working individual with gains* | 15%–20% | Capital Gains + NIIT | ~18%–23% |
*Ordinary income/capital gains in excess of 0% capital gains bracket.
This kind of planning matters. It isn’t just about minimizing taxes now—it’s also about managing income to improve outcomes over time.
Talking About Tax Benefits Without Overpromising
Yes, tax deferral is a benefit. But it’s more powerful when you present it with balance. Consider framing the benefits in these ways:
“It’s not about avoiding taxes—it’s about managing when and how you pay them.”
“We’re not deferring taxes forever—we’re managing when and how we pay them.”
“The goal is to help you keep more of what you’ve earned and use it when you need it most.”
“Often, the goal is to pay taxes when you’re in a lower tax bracket, so you maximize your after-tax income.”
Many clients are focused on reducing this year’s taxes. Great advisors help them look at the big picture: reducing taxes over a lifetime.
Don’t Overlook the Flexibility of Non-Qualified Annuities
There’s a lot of attention on income guarantees—and rightly so. But I’d encourage you to spotlight flexibility as well. Non-qualified annuities can:
Avoid required distributions during the client’s lifetime
Provide stretch options to beneficiaries
Let clients choose when to recognize income
These contracts offer real flexibility if clients know how to use them. That’s your value as the advisor: helping them understand the levers they have, so they can make the most of them.
Final Thought: Make Taxation Part of the Planning Conversation
At Delaware Life, we are committed to helping advisors have better conversations—not just about products, but about smart, strategic planning. Annuity taxation doesn’t need to be a barrier. In the right hands, it’s a bridge to client understanding and long-term value.
Want to learn more? Visit delawarelife.com or connect with your wholesaler for details on our fixed annuities, FIAs, or income solutions.