By Hans Goldstein, Founder, Retirement Literacy Foundation. He is also a licensed California insurance producer (#4273294). Education, not a product recommendation.Published · Methodology dated October 3, 2026
When $100,000 of after-tax savings grows to $200,000, cashing out a deferred annuity owes $24,000 of federal tax in the 24% bracket, versus $15,000 for a taxable brokerage account at the 15% capital gains rate. At death the gap widens: the annuity heir owes ordinary income tax on the full $100,000 gain, while the brokerage heir gets a step-up in basis and owes nothing on it.
Scope: non-qualified money only
Everything on this page is about annuities bought with after-tax savings (non-qualified). Inside a 401(k) or IRA, an annuity and a brokerage-style investment are taxed the same way: every withdrawal is ordinary income, and IRA assets get no step-up either way. For qualified money the choice comes down to guarantees, income, fees and sequence risk, not tax.
Three rules that work against growth in an annuity
- Gains come out first (LIFO). Withdrawals from a non-qualified deferred annuity before annuitization are treated as earnings first, up to the gain in the contract (IRC 72(e)). Loans and pledges count as withdrawals.
- Ordinary income, never capital gains. Annuity gain is ordinary income, and it is also net investment income for the 3.8% net investment income tax (IRS Publication 939). Before age 59 1/2, a 10% additional tax applies to the taxable part unless an exception fits (IRC 72(q)).
- No step-up at death. A deferred annuity’s gain is income in respect of a decedent; the beneficiary owes ordinary income tax on it, and the basis step-up under IRC 1014 does not apply (Rev. Rul. 2005-30). Inherited brokerage shares generally get a new basis equal to value at death.
Permanent life insurance, by contrast, is basis-first: withdrawals up to what you paid in are generally not taxed if the policy is not a modified endowment contract and stays in force (IRC 72(e)(5)), and a lapse or surrender with a loan outstanding can create taxable income.
The worked example: $100,000 grows to $200,000 in 10 years
Same money, same growth (about 7.18% a year), two containers, two states. Single filer. Federal ordinary rate 24% and capital gains rate 15% are assumed to apply to the whole gain (the 2026 single 24% bracket runs from $105,700 to $201,775 of taxable income, and the 15% capital gains rate runs to $545,500). Texas has no state income tax. California taxes capital gains as ordinary income, shown here at its 9.3% bracket rate. The 3.8% net investment income tax, if it applies, hits both the annuity gain and the capital gain, so it does not change the gap.
| State and outcome | Tax | After tax | 10-yr after-tax return |
|---|---|---|---|
| Texas: Non-qualified deferred annuity, cashed out | $24,000 | $176,000 | 5.82% |
| Texas: Taxable brokerage, sold (no dividend drag) | $15,000 | $185,000 | 6.35% |
| Texas: Taxable brokerage with 1.5% dividends taxed yearly (hypothetical) | $11,747 | $184,143 | 6.30% |
| Texas: At death: annuity to heir (ordinary income, no step-up) | $24,000 | $176,000 | |
| Texas: At death: brokerage to heir (step-up in basis) | $0 | $200,000 | |
| California: Non-qualified deferred annuity, cashed out | $33,300 | $166,700 | 5.24% |
| California: Taxable brokerage, sold (no dividend drag) | $24,300 | $175,700 | 5.80% |
| California: Taxable brokerage with 1.5% dividends taxed yearly (hypothetical) | $18,905 | $174,445 | 5.72% |
| California: At death: annuity to heir (ordinary income, no step-up) | $33,300 | $166,700 | |
| California: At death: brokerage to heir (step-up in basis) | $0 | $200,000 |
The federal gap is the same in both states, because California taxes the annuity gain and the capital gain at the same state rate. California simply makes both outcomes smaller. Here is the federal gap at three tax levels, assuming the whole $100,000 gain falls in that bracket:
| Federal bracket pairing | Annuity tax | Brokerage tax | Annuity pays more |
|---|---|---|---|
| 22% ordinary vs 15% capital gains | $22,000 | $15,000 | $7,000 |
| 24% ordinary vs 15% capital gains | $24,000 | $15,000 | $9,000 |
| 37% ordinary vs 20% capital gains | $37,000 | $20,000 | $17,000 |
At 0% capital gains (taxable income under $49,450 single in 2026) the brokerage tax can be zero on the part of the gain that fits.
Being fair: what narrows the gap
Deferral is real. A taxable account usually pays some tax every year on dividends and fund distributions. In the hypothetical row above, a fund paying 1.5% a year in qualified dividends taxed each year ends about $4,111 lower before the final sale in Texas, and the reinvested dividends raise its basis. The brokerage still comes out ahead here, by about $8,143 in Texas, but the gap is smaller, and a higher-turnover fund taxed at ordinary rates could erase it.
Annuities have two strengths no brokerage account has:
- Lifetime income that cannot stop. An immediate annuity or an annuitized contract pays as long as you live, backed by the claims-paying ability of the insurer. For an immediate annuity bought with after-tax money, the exclusion ratio treats part of each payment as a tax-free return of your own principal (IRC 72(b)), which is the most favorable way annuity money is taxed.
- Less sequence-of-returns risk. A fixed or floored contract does not fall with the market, so a bad year early in retirement does not force you to sell low. See our sequence-risk research.
Use annuities for what they are great at, income and protection, not as a tax-efficient growth account for after-tax money you expect to leave to heirs.
Methodology (dated October 3, 2026)
Hypothetical arithmetic, not a projection. $100,000 of after-tax money grows to $200,000 over 10 years (7.18% a year compounded) in each account. The annuity is cashed out in full at year 10 with no surrender charge; the brokerage account is sold at year 10 with a long-term gain. Federal: single filer, 24% ordinary rate and 15% long-term capital gains rate assumed to apply to the whole $100,000 gain (2026 thresholds from Rev. Proc. 2025-32). State: Texas has no personal income tax; California taxes capital gains as ordinary income and is shown at its 9.3% bracket rate. The 3.8% net investment income tax applies to both annuity gains and capital gains above $200,000 MAGI (single), so it is excluded from the gap. The dividend-drag row assumes 5.68% price growth plus a 1.5% qualified dividend taxed each year at 15% (plus 9.3% in CA) and reinvested. After-tax return is the 10-year compound rate on the after-tax amount. Not tax advice.
Sources
- 26 U.S.C. 72 (annuities: income-first withdrawals, 72(b) exclusion ratio, 72(q) penalty), Cornell LII
- IRS Publication 939 (12/2025): nonqualified annuity distributions are net investment income
- IRS Rev. Rul. 2005-30, IRB 2005-20 (annuity death benefit is income in respect of a decedent)
- 26 U.S.C. 1014 (basis of property acquired from a decedent), Cornell LII
- 26 U.S.C. 1411 (net investment income tax), Cornell LII
- IRS Rev. Proc. 2025-32 (2026 brackets and capital gains thresholds)
- California Franchise Tax Board: capital gains and losses (no lower rate for capital gains)
- California FTB 2025 Form 540 booklet and tax rate schedules
Goldstein, H. (2026, October 3). The Non-Qualified Annuity Tax Trap: Gains First, Ordinary Income, No Step-Up. Retirement Literacy Foundation. https://retirementliteracyfoundation.org/research/non-qualified-annuity-tax-trap/
Journalists and educators may quote and chart these findings with a link to this page. Data: download the CSV.
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