The Basic Rule
You pay taxes on the gains, not on money you already paid taxes on (your 'basis'). How and when depends on whether your annuity is 'qualified' (inside IRA/401k) or 'non-qualified' (after-tax money).
Non-Qualified Withdrawals
IRS uses 'last-in, first-out' (LIFO). Gains come out first. Example: $100K in, grew to $140K. Withdraw $50K → first $40K taxed as ordinary income (gains), last $10K is tax-free return of basis. You don't get tax-free money until all gains withdrawn.
Qualified Withdrawals
Simple: every dollar is taxed as ordinary income. No basis to recover because contributions were pre-tax.
10% Early Withdrawal Penalty
Withdraw before 59½ = 10% federal penalty on taxable portion, in addition to regular income taxes. Exceptions: death, disability, 72(t) distributions, certain medical/education expenses.
Death Benefit Taxation
Death doesn't eliminate taxes. Gains taxed as ordinary income by original owner or beneficiaries. Annuity death benefits do NOT receive step-up in basis like stocks or real estate — significant disadvantage.
1035 Exchanges
Tax-free transfer between annuities. Money goes direct — you never take possession. Basis carries over. Doesn't eliminate surrender charges, just avoids taxable event.