Tax Strategy
Tax-deferred growth: what it actually means when you withdraw
Your money inside an annuity, 401(k), or IRA grows without being taxed each year. That is the benefit. But every dollar that grew tax-deferred is taxed as ordinary income when you take it out. Not at the lower capital gains rates most people expect. That distinction changes how you plan distributions, Roth conversions, and Social Security timing.
What "tax-deferred" actually means
In a regular taxable brokerage account, you pay taxes every year on dividends, interest, and realized capital gains. That annual tax bill reduces your investable balance. Tax deferral removes that drag. Your entire balance (including the amount you would have paid in taxes) stays in the account and keeps compounding.
The trade-off: you are not avoiding taxes. You are delaying them. The IRS still gets paid, just later. Ideally, you withdraw in retirement at a lower income bracket than your working years.
The compounding advantage in numbers
Starting with $100,000 at a 5% annual return. The taxable account pays 24% federal tax on gains each year. The tax-deferred account pays nothing until withdrawal.
Illustrative only. Actual returns vary. Taxable figure assumes 5% growth with 24% federal tax on gains annually. Does not account for state taxes or changes in tax rates.
How withdrawal taxes actually work
Here is the part most people miss. When you withdraw from a tax-deferred annuity, 401(k), or traditional IRA, the money is taxed as ordinary income, at the same rate as your salary. It is not taxed at capital gains rates, even though the growth came from investment gains.
- 10% on income up to $11,925
- 12% on $11,926–$48,475
- 22% on $48,476–$103,350
- 24% on $103,351–$197,300
- 32%+ on income above that
- 0% on income up to $47,025 (single)
- 15% on $47,026–$518,900
- 20% on income above that
Tax-deferred withdrawals do NOT qualify for these rates.
LIFO: gains come out first
In non-qualified annuities (funded with after-tax money), the IRS uses Last In First Out (LIFO) accounting. Your gains are treated as the most recently added money, so they come out first.
If you put $100,000 into a non-qualified annuity and it grew to $160,000, the first $60,000 you withdraw is fully taxable as ordinary income. Only after you have withdrawn all the gains do you start receiving your original $100,000 tax-free.
Qualified vs. non-qualified annuities
The tax treatment of your annuity depends on how it was funded. This distinction affects every withdrawal decision you make.
The 10% early withdrawal penalty
Withdrawing from any tax-deferred account before age 59½ triggers a 10% federal penalty on top of ordinary income tax. This applies to annuities, traditional IRAs, and 401(k)s.
Example: $30,000 withdrawal at age 55, 24% tax bracket
You keep $19,800 of your $30,000. State taxes would reduce this further.
Exceptions to the 10% penalty
The penalty does not apply in certain circumstances:
- Death or disability: distributions to a beneficiary or due to total disability
- Substantially Equal Periodic Payments (SEPP / 72(t)): structured withdrawals over your life expectancy
- Annuitization: converting the contract to a stream of substantially equal payments
- Terminal illness: distributions within 84 months of a terminal diagnosis
- Certain 401(k) plans: separation from service at age 55 or older
Required Minimum Distributions (RMDs) at age 73
If your annuity is inside a qualified account (a 401(k) rollover, traditional IRA, or other tax-deferred plan), the IRS requires you to start taking withdrawals at age 73 under SECURE 2.0 Act rules. You cannot leave the money there indefinitely.
- RMD amount is calculated by dividing your account balance by your IRS life expectancy factor each year.
- Failing to take your RMD triggers a 25% excise tax on the amount you should have withdrawn.
- If you already have an annuity with income payments that satisfy the RMD requirement, distributions from that annuity count.
- A Qualifying Longevity Annuity Contract (QLAC) can defer RMDs on up to $200,000 until age 85, which is a legitimate planning strategy for people worried about longevity.
Planning your withdrawals strategically
The order in which you draw from different accounts in retirement matters more than most people realize. Here are the four questions that drive the decision.
If you retire early and have several low-income years before Social Security and RMDs kick in, those years are prime candidates for Roth conversions. You pay tax now at a lower rate, and future withdrawals from the Roth are completely tax-free.
Up to 85% of your Social Security benefit becomes taxable once your combined income exceeds $34,000 (single) or $44,000 (married). Annuity withdrawals count toward that threshold. Taking annuity income before you claim Social Security, or drawing from Roth assets instead, can save thousands per year.
Tax-deferred accounts inherited by non-spouse beneficiaries must be withdrawn within 10 years under the SECURE Act. A large inherited IRA can push your heirs into a high bracket during their peak earning years. Roth conversions during your lifetime can eliminate that burden.
Medicare Part B and D premiums increase with income (IRMAA surcharges). In 2025, a couple with income above $212,000 pays roughly $420/month more in Medicare premiums than a couple under that threshold. Annuity withdrawals count as income. Managing the size and timing of distributions can keep you below these thresholds.
The 1035 exchange: moving between annuities tax-free
If you own a non-qualified annuity that no longer fits your situation (whether because of lower rates, excessive fees, or the wrong product type), a Section 1035 exchange lets you move it to a new annuity contract without triggering a taxable event. Think of it as the non-qualified equivalent of a direct rollover.
- The exchange must go directly between insurance companies (similar to a direct rollover). If you receive the funds first, it may be taxable.
- Your cost basis carries over. If you put in $100,000 and the contract is worth $160,000, your new contract starts with a $100,000 basis.
- Surrender charges on the old contract still apply. The 1035 exchange does not waive those fees.
- Only annuity-to-annuity or life insurance-to-annuity exchanges qualify under Section 1035.
What to confirm before funding a tax-deferred annuity
Tax deferral is only one factor. These are the questions that actually determine whether a specific contract is right for your situation.
If you will be in the same or higher bracket in retirement, the deferral benefit shrinks. For some high earners, a Roth conversion now beats a tax-deferred annuity later.
Rolling a 401(k) into a qualified annuity is a non-taxable event. Funding a non-qualified annuity with after-tax money is also fine. Just know the tax math is different for each withdrawal you take.
If you need liquidity before the surrender period ends, withdrawals beyond the free withdrawal amount (typically 10%/year) trigger surrender charges of 7–9% that can offset years of tax-deferred compounding.
If the annuity is inside an IRA and you already have several tax-deferred accounts, adding another one increases your future RMD burden. Run the numbers with a professional who can model projected income in your 70s and 80s.
How does this interact with your specific situation?
Tax treatment of annuity withdrawals depends on your bracket, account type, RMD timing, and Social Security strategy. A licensed professional who works across multiple carriers can model this for your specific situation, at no cost to you.
Talk to a licensed agent →This page is for educational purposes only and does not constitute tax, financial, legal, or investment advice. Tax rules are subject to change. Always consult a qualified tax professional before making annuity or rollover decisions.