TLDR
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Yes — annuity payments are generally taxable, but how much depends on whether the annuity is qualified or non-qualified.
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Qualified complete guide to annuities in Kentucky (funded with pre-tax dollars from an IRA or 401k) are taxed as ordinary income in full when distributed.
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Non-qualified annuities (funded with after-tax dollars) use the exclusion ratio — only the earnings portion is taxed, not the principal you already paid taxes on.
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Kentucky taxes annuity income at a flat 4.5% state rate, in addition to federal income tax.
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Planning ahead matters — withholding elections, timing of distributions, and retirement account strategy all affect your annuity tax bill.
Most people learn this too late — usually when the first annuity check arrives and it’s smaller than expected because taxes were withheld.
Annuity income is taxable. But how it’s taxed, and how much you owe, depends on answers to questions most buyers never think to ask when they purchase the contract.
This is the breakdown.
The First Question: Qualified or Non-Qualified?
Every annuity falls into one of two buckets, and the tax treatment is completely different.
Qualified annuities are funded with pre-tax dollars — money from a traditional IRA, 401(k), 403(b), or other tax-deferred retirement account. Because you never paid income tax on that money going in, every dollar coming out is taxed as ordinary income. No exceptions. Full distributions are subject to federal and Kentucky state income tax.
Non-qualified annuities are funded with after-tax dollars — money you’ve already paid income tax on. Because you’ve already been taxed on the principal, only the growth (the earnings above your original investment) is taxed when distributed. The principal portion comes back tax-free.
Most people who buy annuities outside of an IRA or workplace retirement plan have non-qualified contracts. Most people who roll an IRA or 401(k) into an annuity have a qualified contract.
If you’re not sure which you have, look at the funding source. Did the money come from a pre-tax retirement account? Qualified. Did you write a check from personal savings? Non-qualified.
How the Exclusion Ratio Works for Non-Qualified Annuities
If you have a non-qualified annuity and you annuitize it — meaning you convert the balance to a stream of monthly payments — the IRS uses a formula called the exclusion ratio to determine how much of each payment is taxable.
Here’s the basic concept. Suppose you put $100,000 of after-tax money into an annuity, and it grew to $180,000 over 15 years. When you annuitize, your total investment (basis) is $100,000 and your total earnings are $80,000. The exclusion ratio determines what percentage of each payment represents your tax-free return of principal and what percentage represents taxable earnings.
If your contract pays you $1,000/month for a 20-year period certain, and the exclusion ratio calculates to 55%, then $550 of each payment is tax-free return of basis and $450 is taxable earnings.
Once you’ve received payments long enough to fully recover your basis, all remaining payments become 100% taxable. The IRS publishes life expectancy tables used to calculate these ratios — your annuity carrier should provide the exclusion ratio calculation when annuitization begins.
Federal Taxes on Annuity Income
Annuity distributions are taxed as ordinary income at the federal level — not at the lower capital gains rate. This matters because long-term investment gains from stocks and mutual funds are often taxed at 0%, 15%, or 20%. Annuity earnings don’t qualify for those rates.
For 2026, federal ordinary income tax rates range from 10% to 37%. Most Kentucky retirees drawing annuity income fall in the 12%–22% bracket depending on their total income. A retiree with $45,000 in combined Social Security and annuity income, for example, might fall in the 12% federal bracket with minimal Social Security taxation.
Pre-59½ withdrawals from a deferred annuity are also subject to a 10% early withdrawal penalty from the IRS — similar to the penalty on early IRA or 401(k) distributions. There are exceptions (death, disability, substantially equal periodic payments), but the penalty applies to most early withdrawals.
Kentucky State Taxes on Annuity Income
Kentucky taxes annuity income as ordinary income. As of 2026, Kentucky’s flat individual income tax rate is 4.5%.
If you receive $20,000 per year in taxable annuity distributions, Kentucky takes $900 of that (4.5% × $20,000) in addition to whatever you owe federally.
Kentucky does not have a separate pension exclusion that applies to annuities from private carriers — though Social Security benefits are fully exempt from Kentucky state income tax. Qualified pension income from certain government sources may receive some exclusion, but private annuity income from an insurance carrier is generally taxed at the full 4.5% rate.
The Sandra Scenario: Planning Ahead Saves Real Money in Georgetown
Sandra is 68 and lives in Georgetown. She has a non-qualified fixed annuity she purchased 12 years ago with $85,000 from personal savings. The contract has grown to $142,000. She’s ready to begin taking income and calls Nova to ask how the taxes will work.
The carrier calculates her exclusion ratio at 59.8% — meaning 59.8 cents of every dollar she receives is a tax-free return of her original investment. Her annual distribution of $9,600 will include approximately $5,741 that is tax-free and $3,859 that is taxable as ordinary income.
At the 12% federal rate, she owes roughly $463 in federal tax on that $3,859. At Kentucky’s 4.5% rate, she owes $174 in state tax. Total annual tax on a $9,600 distribution: approximately $637.
Without the exclusion ratio, if this were a qualified annuity, the full $9,600 would be taxable — federal tax at 12% ($1,152) plus Kentucky at 4.5% ($432) equals $1,584 annually.
Sandra’s non-qualified status saves her nearly $950 in taxes per year compared to an identical qualified annuity — solely because she used after-tax dollars to fund it.
Withholding Elections: Getting This Right Upfront
When you begin receiving annuity payments, you’ll be asked to make a withholding election. You can choose to have federal and Kentucky state taxes withheld automatically from each payment — or you can opt out and pay estimated taxes quarterly.
Most retirees benefit from withholding. It eliminates the risk of an unexpected tax bill in April and prevents potential underpayment penalties from the IRS.
Federal withholding on periodic annuity payments defaults to treating the payment as if you were married with three allowances — which may or may not match your actual tax situation. Review the withholding calculation when you first elect distributions and adjust as needed.
Kentucky requires withholding on annuity payments unless you opt out. If your total income is low enough that you owe no Kentucky tax, you can file an exemption form with the carrier.
If you change withholding mid-year, it affects only future payments — not taxes already withheld.
Lump Sum vs. Annuitization: The Tax Difference
Some annuity holders decide to take a lump sum rather than periodic payments — especially if they need a large amount for a one-time expense or want to move assets.
The tax implications of a lump sum are significant. For a qualified annuity, the entire lump sum is ordinary income in the year received. A $200,000 qualified annuity lump sum could push a Kentucky retiree’s income into the 24% or 32% federal bracket for that year — a much higher rate than spreading distributions over 20 years.
For a non-qualified annuity, a lump sum triggers taxes on all accumulated earnings in a single year — again, potentially pushing income into a higher bracket.
Annuitization spreads the tax burden over the payment period. A lump sum concentrates it. For most retirees, annuitization is more tax-efficient unless there is a compelling reason to take the full amount at once.
There is a middle option: systematic withdrawals. Rather than full annuitization or a full lump sum, you withdraw a fixed amount each year on a schedule. The tax treatment follows the same exclusion ratio logic, but you retain more control over the amount and timing.
1099-R Forms and Reporting Annuity Income
Each January, your annuity carrier sends a 1099-R form reporting the prior year’s distributions. Box 1 shows the total distribution amount. Box 2a shows the taxable amount. Box 2b may indicate that the taxable amount is not determined — which sometimes means you need to calculate it yourself using the exclusion ratio.
If you receive a 1099-R with Box 2b checked, work with a tax professional or use the IRS simplified method worksheet to determine the taxable portion. Reporting the wrong amount — either too little or too much — creates problems.
The 1099-R also contains distribution codes in Box 7 that indicate the type of distribution. Code 7 is a normal distribution (age 59½+). Code 1 is an early distribution subject to the 10% penalty. Verify that the code matches your actual situation.
How an Independent Agent and a Tax Professional Work Together
Annuity planning sits at the intersection of insurance and tax strategy. An independent insurance agent can help you understand which type of annuity you have, what the distribution options look like, and how different payout structures affect your annual income.
A CPA or tax advisor handles the specific numbers — calculating exclusion ratios, modeling bracket impacts, and completing the actual tax return.
Neither can fully replace the other. The mistake some people make is buying an annuity without talking to both. The annuity structure you choose — qualified vs. non-qualified, annuitization vs. systematic withdrawal, lump sum vs. lifetime payments — has tax consequences that follow you for decades.
See our companion article on What Are Annuities and How Do They Work in Kentucky? and learn more about how individual life insurance fits alongside annuities in a complete retirement plan.
Final Takeaways
✅ Qualified annuities (pre-tax funded) are fully taxable as ordinary income when distributed — every dollar out is a taxable dollar.
✅ Non-qualified annuities (after-tax funded) use the exclusion ratio — only earnings are taxed, not the principal you already paid tax on.
✅ Kentucky taxes annuity income at a flat 4.5% in addition to federal ordinary income tax.
✅ Pre-59½ withdrawals trigger a 10% IRS penalty on top of regular income taxes — unless an exception applies.
✅ Withholding elections at distribution time matter — set them correctly upfront to avoid underpayment penalties.
✅ Lump sums create large single-year tax events — periodic distributions are usually more tax-efficient.
✅ Talk to both an insurance agent and a CPA before choosing a distribution strategy — the tax implications follow you for the life of the contract.
Frequently Asked Questions
Are annuity payments taxable in Kentucky?
Yes. Kentucky taxes annuity income as ordinary income at a flat rate of 4.5%. In addition, federal income tax applies — at ordinary income rates ranging from 10% to 37% depending on your total income. The amount subject to Kentucky state tax depends on whether your annuity is qualified (fully taxable) or non-qualified (only earnings are taxable).
How does Kentucky tax a non-qualified annuity?
For a non-qualified annuity, Kentucky — like the federal government — taxes only the earnings portion of each distribution. The principal (your original after-tax investment) returns tax-free. The exclusion ratio, provided by your carrier, determines what percentage of each payment is taxable versus tax-free.
What is the exclusion ratio on an annuity?
The exclusion ratio is the percentage of each annuity payment that represents a tax-free return of your original investment. It’s calculated by dividing your total investment (basis) by the expected total value of payments over your lifetime. The remainder of each payment is taxable earnings.
Is there a Kentucky-specific tax exemption for annuity income?
Kentucky does not offer a general exclusion for private annuity income from insurance carriers. Social Security benefits are exempt from Kentucky state income tax, and some government pension income may qualify for exclusions, but standard annuity payments from private carriers are taxed at the full 4.5% flat rate.
What happens if I take a lump sum from my annuity?
A lump sum withdrawal creates a large, single-year taxable event. For a qualified annuity, the entire amount is ordinary income in the year received — potentially pushing you into a significantly higher tax bracket. For a non-qualified annuity, all accumulated earnings are taxable in the year of the lump sum distribution. In most cases, periodic distributions are more tax-efficient.
Can I avoid taxes on annuity income?
You cannot permanently avoid taxes on annuity earnings — they are taxable when distributed. However, you can manage the tax impact through careful timing of distributions, withholding elections, strategic use of qualified vs. non-qualified funds, and coordination with other income sources to stay in lower brackets. A tax professional can model these scenarios for your specific situation.
What is a 1099-R and why does my annuity send me one?
A 1099-R is the IRS form that reports annuity distributions each year. Box 1 shows total distributions, Box 2a shows the taxable portion, and Box 7 contains a distribution code indicating the type of withdrawal. You’ll receive this form each January from your annuity carrier and need it to file your federal and Kentucky state income tax returns.
👉 Have questions about your annuity’s tax treatment? Call 📞 859-687-2004 or visit Nova Insurance Group — we help Kentucky families understand their full retirement income picture.
📞 859-687-2004 — Prepared. Not panicked.
Steve Straub | Nova Insurance Group | 99 Wind Haven Dr., Suite 1, Nicholasville, KY 40356 Serving Lexington, Nicholasville, Wilmore, Georgetown, Richmond, and Danville.
About the Author
Steve Straub is the principal agent of Nova Insurance Group, an independent insurance agency serving Lexington, Nicholasville, and Central Kentucky. With 13 years in the insurance industry — including roles as an underwriter, risk manager, loss control specialist, and sales manager at a Fortune 400 insurance carrier — Steve brings carrier-level insight into how policies are written, priced, and paid out. He holds licenses in Property, Casualty, Life, and Health insurance. As an independent agent, Steve represents multiple carriers to find the right fit for each client — not the best fit for a company quota.
