She Pulled $25,000 From Her $250,000 Annuity at 70 to Help Her Son, Inside the ‘Free’ 10% the Contract Allows. The Insurer Charged Nothing. The IRS Taxed Every Dollar, Because Gains Come Out First
The insurer kept its promise and charged her nothing, but the IRS had its own claim on those dollars, and the word 'free' turned out to cover far less than she expected.
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A common annuity feature, the penalty-free withdrawal, works alongside federal tax rules for non-qualified annuities. For example, a 70-year-old with a $250,000 contract takes out $25,000 to help her son. Today, many people are in a similar position. LIMRA reported U.S. annuity sales of $121.2 billion in the second quarter of 2026, a first-half record. Many of those contracts include a free withdrawal provision, and owners often assume the word “free” covers taxes too.
What the 10% Free Withdrawal Actually Covers
Most deferred annuities charge surrender fees in the early years of the contract. A typical free withdrawal provision lets the owner take out up to 10% of the contract value each year without paying those fees. On this contract, 10% comes to $25,000. Her withdrawal falls exactly within the allowance, so the insurer takes nothing out.
This agreement between the owner and the insurance company controls only what the insurer charges. However, the IRS applies its own rules to the same dollars, and those rules depend on how the contract was funded and when it was bought.
Why Gains Leave the Contract Before Principal
A non-qualified annuity is bought with money that has already been taxed, so only the growth is taxable. For most non-qualified deferred annuities bought after August 13, 1982, withdrawals made before the annuity starting date count as earnings first and principal second. This order is called last in, first out, or LIFO. The earnings are taxed as ordinary income rather than at capital gains rates.
Say the owner paid $150,000 into the contract years ago and it has grown to $250,000. That leaves $100,000 in accumulated profits. Because gains come out first, the IRS treats her entire withdrawal as earnings. While the cost basis does not change, the untaxed profits left in the contract fall to $75,000. This means the next withdrawal will also be fully taxable until those profits run out. Only after that does principal start coming out tax-free.
What the Withdrawal Costs at Tax Time
At our example age, the owner does not owe the 10% additional federal tax that generally applies to annuity withdrawals taken before age 59½. That leaves ordinary income tax on the earnings portion of the withdrawal. If the whole withdrawal is taxed at 22%, the federal bill is $5,500. At a 12% rate, it is $3,000. State income tax, where it applies, would come on top of either amount.
The extra income can also affect a retiree who collects Social Security. Depending on filing status and combined income, up to 85% of benefits can be taxed. For single filers, that level applies once combined income goes above $34,000. A withdrawal considered entirely as income can push some retirees over that line in the year they take it.
The money she gives her son is handled separately. The annual gift tax exclusion for 2026 is $19,000 per person, so a gift of this size generally means filing a gift tax return. The amount above the exclusion is considered against the owner’s lifetime exemption.
How the Same Withdrawal Can Be Taxed Differently
The LIFO rule applies to partial withdrawals from deferred contracts. Contracts bought on or before that 1982 cutoff generally work the other way and return principal first. Owners who annuitize, meaning they turn the contract into a stream of payments, are taxed on a different schedule. Each payment is split into a tax-free return of principal and taxable earnings. A qualified annuity held inside an IRA or 401(k) is 100% taxable no matter the order, because the money going in was never taxed.
Details That Decide the Tax Bill Before Money Moves
Several factors shape the tax result of a withdrawal like this one:
- Cost basis: Insurer statements show how much was paid in and how much is profit. That split determines how much of the withdrawal is taxable.
- Purchase date: Older contracts may follow the principal-first order, which changes the result completely.
- Total income for the year: Social Security, pensions, and required IRA distributions all add up with the annuity earnings.
- Timing: The free withdrawal allowance usually resets each contract year. Splitting a withdrawal across two tax years can keep more of the income in a lower bracket.
The insurer charged nothing, while the tax bill reflected years of deferred growth arriving in a single year. The contract set the surrender charge, and IRS rules set the order in which profits and principal came out. Owners of non-qualified annuities with large built-up profits will see that same order on every withdrawal until the profits are gone (it is one of several quiet drains we cataloged in a free retiree tax trap map). That is likely to affect how and when they use the money.
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David Beren has been a Flywheel Publishing contributor since 2022. Writing for 24/7 Wall St. since 2023, David loves to write about topics of all shapes and sizes. As a technology expert, David focuses heavily on consumer electronics brands, automobiles, and general technology. He has previously written for LifeWire, formerly About.com. As a part-time freelance writer, David’s “day job” has been working on and leading social media for multiple Fortune 100 brands. David loves the flexibility of this field and its ability to reach customers exactly where they like to spend their time. Additionally, David previously published his own blog, TmoNews.com, which reached 3 million readers in its first year. In addition to freelance and social media work, David loves to spend time with his family and children and relive the glory days of video game consoles by playing any retro game console he can get his hands on.
