Tax Truths Last reviewed: 2026-10-03 Part of Tax truths

The Annuity Tax Trap: LIFO, Ordinary Income and No Step-Up

Written and reviewed by Hans Goldstein, licensed insurance producer, NPN 20602398 · CA Insurance License #4273294
Last reviewed October 3, 2026 · Published October 3, 2026

Short answer: a non-qualified deferred annuity grows tax-deferred, but when the money comes out, the gain comes out first (LIFO under IRC §72(e)) and is taxed as ordinary income, with a 10% penalty before 59½. At death there is no step-up in basis: your heirs pay ordinary income tax on the gain. A taxable brokerage account held until death gets a step-up, and a life insurance death benefit is generally income-tax-free. Annuities still earn their place for guarantees and deferral; just know the exit cost.

Goldstein Take: Taxes on $100,000 of non-qualified growth (hypothetical)

Goldstein Take · Hans's editorial verdict · reviewed Oct 3, 2026 · how we grade →

Option	Verdict	One-line take
Life insurance death benefit	A	Generally income-tax-free to heirs under §101(a). Lifetime access is tax-free only within the loan and basis rules.
Taxable brokerage, held to death	A-	Step-up under §1014 wipes out the lifetime gain for heirs. You paid tax on dividends along the way.
Taxable brokerage, sold in your lifetime	B	Long-term capital gains rates, usually lower than ordinary income rates.
Non-qualified annuity, cashed out or inherited	C	Gain first, all ordinary income, no step-up. Deferral is the benefit; the exit is the cost.

Bottom line: With non-qualified (after-tax) money, an annuity is a good tool for guaranteed rates and income and a poor tool for leaving growth to heirs, and that is rarely said out loud. Inside an IRA or 401(k), the tax treatment is the same either way.

Educational, not tax advice. Grades answer only the question in the title, for a typical case; your facts can change the answer.

Where annuities win

Lifetime income that can't stop. A SPIA, or an income rider or annuitization, pays as long as you live, backed by the claims-paying ability of the issuing insurer.
Less sequence-of-returns risk. Guaranteed or floored principal (MYGA, FIA) and a guaranteed income floor mean a bad market year early in retirement doesn't force you to sell low (why the first bad years matter most).
Inside an IRA or 401(k), the tax comparison is a wash. Every withdrawal from qualified money is ordinary income whether it sits in an annuity or a brokerage-style investment, and IRA assets get no step-up either way. The tax trap applies only to non-qualified (after-tax) money.

Use annuities for what they're great at, income and protection, not as a tax-efficient growth account. See current MYGA rates, SPIA rates, or get a free annuity review.

How a non-qualified annuity is taxed

A non-qualified annuity is one you bought with after-tax money (not inside an IRA or 401(k)). The premium you paid is your basis. The growth is not taxed each year, which is the real benefit: no 1099 on interest you do not take. The rules bite on the way out:

Gain comes out first. For contracts after August 13, 1982, withdrawals before annuitization are treated as coming from earnings first, then basis (§72(e), Cornell LII). People call this LIFO.
It is ordinary income. Annuity gain is never a capital gain, however long you held it.
A 10% additional tax before 59½ applies to the taxable part, with limited exceptions (§72(q)).
No step-up at death. The stepped-up basis rule in §1014 does not reach annuity gain. It is income in respect of a decedent under §691, so your beneficiary owes ordinary income tax on it (26 U.S.C. §691).

Free annuity review

How much of your annuity would your heirs actually keep?

Send your email and I'll send a plain-English read on your annuity's tax exit: gain, basis, and the options that leave more after tax, within one business day.

We’ll email it to you. Hans Goldstein · NPN 20602398.

Rather talk it through? Or book 15 minutes on Hans’s calendar.

The worked example: $100,000 that grows to $200,000

Same starting money, same growth, three containers. Hypothetical, not tax advice. Assumptions chosen to keep the math simple: a 24% ordinary income bracket for you and for your heir, a 15% long-term capital gains rate, no state tax, and the growth already happened. Real results depend on your brackets, state, and how the money grew.

Hypothetical tax comparison (not a quote, not tax advice)

	Non-qualified annuity	Taxable brokerage	Life insurance
Starting money	$100,000 premium	$100,000 invested	$100,000 of premium
Value later	$200,000 contract value	$200,000 account value	Death benefit set by the policy (often well above premium for a healthy insured)
Taxed along the way?	No (tax-deferred)	Yes, dividends and any gains realized each year	No, while in force
You cash it all out	$100,000 gain x 24% = $24,000 tax	$100,000 gain x 15% = $15,000 tax	Surrender gain above basis is ordinary income, like the annuity
Your heir inherits it	$100,000 gain x heir's 24% = $24,000 tax	Step-up: $0 income tax on the $100,000 lifetime gain	Death benefit generally income-tax-free: $0 income tax
Income-tax cost to heirs	$24,000	$0	$0

Brokerage figures ignore the yearly tax already paid on dividends, which is the brokerage account's real cost. Life insurance has its own costs (insurance charges, fees) and requires health underwriting; a single $100,000 premium would usually make the policy a MEC, which does not change the death benefit's tax treatment but does make lifetime loans and withdrawals taxable gain first. Estate tax, if any, is separate from all three.

Read the bottom row. On money that is meant for heirs, the annuity turns $100,000 of growth into a $24,000 income tax bill in this example, while the brokerage account and the life insurance policy pass the same growth with no income tax. If the money is for your own spending, the gap narrows: a lifetime sale of the brokerage account costs $15,000 versus $24,000 here.

California vs Texas: cashing out non-qualified money after 10 years

This only applies to non-qualified money

Everything on this page is about annuities bought with after-tax (non-qualified) dollars. Inside a 401(k) or IRA, an annuity and a brokerage-style investment are taxed the same: every withdrawal is ordinary income, there is no long-term capital gains rate, and IRA assets get no step-up at death. For qualified money, choose on guarantees, lifetime income, fees and sequence-of-returns protection, not on taxes.

Now make it concrete. Same $100,000 of after-tax money growing to $200,000 over 10 years (7.18% a year before tax), then cashed out, for a California seller and a Texas seller. Texas has no state income tax, so a Texas seller keeps more on both sides, but the dollar gap between the brokerage account and the annuity is the same in both states ($7,000 to $17,000). That is because California taxes capital gains and ordinary income at the same state rate, so the whole gap is federal.

California

Hypothetical, non-qualified (after-tax) dollars: California seller, $100,000 grows to $200,000 in 10 years (7.18% a year before tax), then cashed out

Your bracket (combined rate)	Brokerage, sold (long-term gain)	Non-qualified annuity, cashed out	Brokerage keeps more
Moderate Fed 22% / LTCG 15%, CA 9.3%	$175,700 (5.80% a year)	$168,700 (5.37% a year)	$7,000
Upper Fed 32% / LTCG 15% + 3.8% NIIT, CA 9.3%	$171,900 (5.57% a year)	$154,900 (4.47% a year)	$17,000
High Fed 35% / LTCG 20% + 3.8% NIIT, CA 10.3%	$165,900 (5.19% a year)	$150,900 (4.20% a year)	$15,000
Top Fed 37% / LTCG 20% + 3.8% NIIT, CA 13.3%	$162,900 (5.00% a year)	$145,900 (3.85% a year)	$17,000
At death (heirs inherit instead of you cashing out)	Step-up under §1014: about $0 income tax on the $100,000 lifetime gain	Heirs owe ordinary income tax on the $100,000 gain (income in respect of a decedent, §691)	Often the largest gap

Hypothetical, not tax advice. Combined rate = federal bracket + 3.8% net investment income tax where shown + state rate, applied flat to the whole $100,000 gain. After-tax growth rate = (after-tax value / $100,000) to the 1/10 power, minus 1.

Hypothetical, not tax advice. Non-qualified (after-tax) dollars, California. Same assumptions as the table.

Texas

Hypothetical, non-qualified (after-tax) dollars: Texas seller, $100,000 grows to $200,000 in 10 years (7.18% a year before tax), then cashed out

Your bracket (combined rate)	Brokerage, sold (long-term gain)	Non-qualified annuity, cashed out	Brokerage keeps more
Moderate Fed 22% / LTCG 15%, no Texas income tax	$185,000 (6.35% a year)	$178,000 (5.94% a year)	$7,000
Upper Fed 32% / LTCG 15% + 3.8% NIIT, no Texas income tax	$181,200 (6.12% a year)	$164,200 (5.08% a year)	$17,000
High Fed 35% / LTCG 20% + 3.8% NIIT, no Texas income tax	$176,200 (5.83% a year)	$161,200 (4.89% a year)	$15,000
Top Fed 37% / LTCG 20% + 3.8% NIIT, no Texas income tax	$176,200 (5.83% a year)	$159,200 (4.76% a year)	$17,000
At death (heirs inherit instead of you cashing out)	Step-up under §1014: about $0 income tax on the $100,000 lifetime gain	Heirs owe ordinary income tax on the $100,000 gain (income in respect of a decedent, §691)	Often the largest gap

Hypothetical, not tax advice. Non-qualified (after-tax) dollars, Texas. Same assumptions as the table.

Four things to know about these numbers:

California taxes capital gains as ordinary income, so the state rate is the same in both columns. The whole gap comes from the federal difference between ordinary rates and long-term capital gains rates, which is why Texas shows the same dollar gap.
The 3.8% net investment income tax applies to non-qualified annuity gains too, not just to brokerage gains, which is why it appears on both sides.
Flat rates are a simplification. A $100,000 gain in one year can push you into a higher bracket, which hurts the annuity more because all of it is ordinary income. Spreading withdrawals over several years, or annuitizing, can soften that.
For fairness: the annuity paid no tax during the 10 years, while a brokerage account usually pays some tax every year on dividends and fund distributions. That yearly drag narrows the gap shown here.

Is there an annuity-like investment that gets capital gains treatment?

General education only. Hans does not sell securities; talk to a securities-licensed advisor about any of these.

Defined outcome (buffer) funds with 100% downside protection are the closest thing: exchange-traded funds that use options to cap the upside and protect against losses over a set outcome period. The protection applies only if you hold through that period, the upside is capped, and you give up dividends. Shares held over a year are generally taxed as long-term capital gains when sold, though fund distributions can be ordinary income (SEC filing: defined outcome ETF prospectus (11/28/2025)).
Market-linked CDs and principal-protected notes also limit losses, but their returns are usually taxed as ordinary interest income, often accrued each year before you receive it (26 CFR 1.1275-4 (contingent payment debt instruments)), so they do not solve the problem.
Municipal bonds pay interest that is generally free of federal income tax (26 U.S.C. 103 (interest on state and local bonds); California taxes out-of-state munis), but their prices move with interest rates, so they are not principal protected if you sell early.

The takeaway is not “avoid annuities.” It is that taxes are why a MYGA's or a SPIA's tax treatment matters, and why each tool should do the job it does best: annuities for income and protection, other accounts for growth you plan to leave behind.

Why annuities still make sense

None of this makes annuities bad. It makes them a specific tool. Stated fairly:

Deferral compounds. Interest that is not taxed each year keeps earning. In a high bracket over a long hold, that can offset the ordinary income rate at the end.
Guarantees. A multi-year guaranteed annuity (MYGA) locks a rate for the term, backed by the insurer, and often pays more than a CD of similar length (today’s best MYGA rates).
Income you cannot outlive. Annuitizing turns a balance into lifetime payments, and a single premium immediate annuity is taxed like a pension, with part of each payment treated as return of basis (SPIA exclusion ratio explained).
Exchanges. A §1035 exchange lets you move an annuity to another annuity without triggering the gain.

The trap is using a deferred annuity as the account you plan to leave untouched for your kids.

Why this rarely comes up in a sales meeting

This is an incentive point, not an accusation. Annuity sales are paid by commission at the sale, and the step-up comparison mostly matters at death, decades later. A conversation about rates and guarantees closes; a conversation about which account your heirs should inherit is longer and sometimes ends with “keep the brokerage account.” Ask the question yourself, and ask your agent to show the after-tax value to your heirs, not just the rate (how annuity commissions work).

Questions to ask before you buy or keep a deferred annuity

Is this money for my spending, or for my heirs? If heirs, what is the after-tax value to them versus a brokerage account or life insurance?
What is my basis, and how much of the value is untaxed gain today?
If I need money before 59½, how much is penalized?
Would annuitizing (a SPIA) or a §1035 exchange change the tax picture?
If the goal is a legacy, would a life insurance policy funded from the annuity's withdrawals pass more after tax?

Educational, not tax advice. Tax treatment depends on your facts and on current law, which can change. Run your own numbers with your CPA.

Own a deferred annuity? See what your heirs would actually keep.

Send it over. Within one business day you get a written read: your basis and untaxed gain, the after-tax value to heirs, and whether a MYGA, a SPIA, a 1035 exchange or life insurance would leave more.

Educational review, not tax advice. Your CPA confirms the tax numbers.

Rather talk it through? Or book 15 minutes on Hans’s calendar, or call 213-414-2808.

Hans Goldstein · 213-414-2808 · NPN 20602398, independent licensed insurance producer

Frequently asked questions

Are annuities taxed as ordinary income?

Yes. The gain in a non-qualified annuity is taxed as ordinary income when it comes out, never as a capital gain. The part that is a return of your own premium is not taxed.

What does LIFO mean for annuities?

For contracts issued after August 13, 1982, withdrawals before annuitization come from earnings first under IRC §72(e). You pay ordinary income tax on every dollar until all the gain is out, and only then get your basis back.

Do annuities get a step-up in basis at death?

No. Annuity gain is income in respect of a decedent under IRC §691, so the beneficiary owes ordinary income tax on it. Stocks or funds held in a taxable account until death generally get a stepped-up basis under §1014.

Is there a penalty for taking money out of an annuity before 59½?

Generally yes: a 10% additional tax on the taxable part of the withdrawal, with limited exceptions, plus any surrender charge the contract imposes.

Is an annuity in an IRA taxed worse?

No. Inside an IRA or 401(k), an annuity is taxed the same as any other IRA investment: every withdrawal is ordinary income and there is no step-up at death. The tax disadvantage on this page applies only to non-qualified (after-tax) money. For IRA money, compare guarantees, income, fees and sequence-of-returns protection.

Is an annuity or a brokerage account better for heirs?

For growth meant for heirs, a taxable account held until death usually passes more after income tax because of the step-up, and a life insurance death benefit is generally income-tax-free. Annuities fit better for guaranteed rates and lifetime income.

Sources

Hans Goldstein, CA Insurance License #4273294 · NPN 20602398 · Goldstein & Co. LLC dba Goldstein Insurance Services, CA License #6016830

Contact: hans@hansgoldstein.com · 213-414-2808

General education, not tax or legal advice. Tax treatment depends on your facts and on current law, which can change. Talk to your CPA or estate attorney. Guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Guarantees apply only to the contractual terms of the policy. Caps, participation rates, loan rates, charges and dividends are not guaranteed and can change. Hans is paid a commission by the insurer if you buy a policy through him. For life insurance, ask and he will tell you what he earns on your specific policy. Product and company names are trademarks of their owners. Goldstein Insurance Services is an independent agency, not affiliated with or endorsed by any insurer named here. Commission ranges cited are from the public sources listed and vary by insurer, product, term, issue age and state. Annuities have surrender charges and other limitations; read the contract and disclosure before you buy.