How are nonqualified plan distributions taxed?

Qualified versus nonqualified

Publication 575 sorts plans into two camps, and the tax treatment of a withdrawal depends on which camp yours is in. A qualified plan is a qualified employee plan, qualified employee annuity or 403(b) tax-sheltered annuity. Anything else is a nonqualified plan, and the publication gives examples: a private annuity, a purchased commercial annuity, or a nonqualified employee plan. The most common case for individuals is an annuity contract bought directly from an insurance company with after-tax money.

Before the annuity starting date: earnings first

When you take a nonperiodic distribution from a nonqualified plan before the annuity starting date, it is allocated first to earnings, which are taxable, and then to your cost, which is tax free. You include in gross income the smaller of two numbers: the amount you received, or the amount by which the contract’s cash value immediately before the distribution, figured without considering any surrender charge, exceeds your investment in the contract.

The publication’s example: you bought an annuity and, before the annuity starting date, receive $7,000. The contract has a cash value of $16,000 and your investment is $10,000. The earnings are $6,000, so $6,000 is taxable and the remaining $1,000 is a tax-free return of investment. This is the opposite order from a qualified plan, where the tax-free amount is spread proportionally. The calculator above runs exactly this comparison.

Taxable portions of nonqualified distributions may also be subject to the net investment income tax; the publication refers to the Instructions for Form 8960.

Exceptions to the earnings-first rule

Three kinds of payments before the annuity starting date are not subject to the allocation rule, and you include the payment only to the extent it exceeds the cost of the contract: distributions in full discharge of the contract (a refund of what you paid, or complete surrender, redemption or maturity); distributions from life insurance or endowment contracts that are not modified endowment contracts and are not received as an annuity; and distributions under contracts entered into before August 14, 1982, to the extent allocable to investment made before that date.

For a contract bought before August 14, 1982 with later additions, the order is: your pre-August 14, 1982 investment (tax free), then earnings on that investment (taxable), then earnings on later investment (taxable), then your later investment (tax free).

After payments begin: the General Rule

Once annuity payments start, you use the General Rule for a nonqualified plan. Under it, the tax-free part of each payment depends on the ratio of your cost to the total expected return, which is the amount you and other eligible annuitants can expect to receive, figured with IRS actuarial tables. The tables and full method are in Publication 939; the 2025 Publication 575 explains who must use the General Rule but does not teach it. A refund feature, where a beneficiary or estate gets money back if the annuitants die early, reduces your cost for this purpose.

Payments on or after the annuity starting date

A nonperiodic payment from the contract on or after the annuity starting date must generally be included in gross income in full. A cost-of-living increase in your pension is the publication’s example of an amount not received as an annuity and fully taxable. If your regular payments shrink because you took a nonperiodic amount, part of that amount can be excluded, using a fraction based on the reduction. A payment that fully discharges the contract is taxable only to the extent it exceeds your remaining cost.

Loans, transfers and exchanges

Borrowing against a commercial annuity is treated as a nonperiodic distribution, as is pledging or assigning part of the contract, and the allocation rules decide how much is taxable. Transferring an annuity contract issued after April 22, 1987 without full and adequate consideration is treated as a distribution equal to the excess of cash surrender value over your investment, except between spouses or incident to divorce. A tax-free exchange of one annuity contract for another is possible when the annuitant stays the same.

Limits

The 10% additional tax on early distributions can apply to the taxable part of a nonqualified annuity withdrawal before age 59½ unless an exception applies. State rules differ. This page follows the 2025 publication and does not replace Publications 575 and 939 or advice from a tax professional.

Sources

• IRS Publication 575, Pension and Annuity Income (2025): General Rule; Taxation of Nonperiodic Payments; Distribution Before Annuity Starting Date From a Nonqualified Plan; Distribution On or After Annuity Starting Date; Loans Treated as Distributions and Transfers of Annuity Contracts. Read November 2, 2026.

Edition read: Publication 575 (2025), for use in preparing 2025 returns. Dollar limits and dates in this publication are for 2025; check the current publication and form instructions for your tax year. This page summarizes the publication and does not replace it.