Clear Money Guide
What this guide covers
A quick view of the questions and evidence developed below.
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Updated July 30, 2026. Quick answer: Take money out of a non-qualified deferred annuity before the annuity starting date and IRC §72(e)(2)(B) splits it: taxable “to the extent allocable to income on the contract” and tax-free “to the extent allocable to the investment in the contract.” Then §72(e)(3)(A) sets the order — and it puts income first. A partial withdrawal is not part-taxable in proportion. It is fully taxable until the gain is used up.
The allocation rule, built from the statute rather than a slogan
§72(e)(3)(A): an amount is allocable to income “to the extent that such amount does not exceed the excess (if any) of— (i) the cash value of the contract (determined without regard to any surrender charge) immediately before the amount is received, over (ii) the investment in the contract at such time.” And (3)(B): the amount is allocable to investment “to the extent that such amount is not allocated to income under subparagraph (A).”
Read it as an ordering instruction. The whole gain is filled first; only what spills over is your own money coming back. And note the parenthetical in (3)(A)(i) — cash value is measured “without regard to any surrender charge.” The charge reduces what you receive and does not reduce the gain you are taxed on.
Deciding what to do with a contract you already hold
What the contract does is one question; whether to keep it, change it or move on, and what happens to the money either way, is another, and an adviser can work through that with you.
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What that does to the three ways out
| What you do | Tax result |
|---|---|
| Small partial withdrawal, contract still has gain | Fully taxable. None of it is basis |
| Full surrender | The entire gain is taxable in that one year, which can move you through brackets in a way a spread-out exit would not |
| Exchange under §1035(a)(3) | No gain recognised on the exchange itself |
Two consequences follow that people rarely anticipate. The gain is ordinary income, not capital gain — nothing in §72(e) confers capital treatment, and an annuity has no holding-period mechanism to confer it. And on top of the ordinary rate there may be the §72(q) 10 percent penalty, which is measured against the same includible portion — so before 59½ the two provisions stack on exactly the money that comes out first.
Where this rule does not apply, and it matters. This is the rule for a NON-QUALIFIED annuity — bought with after-tax money outside a retirement plan — and only before the annuity starting date. Once payments begin as an annuity, §72(e)(2)(A) applies instead. And an annuity held inside an IRA is not governed by this allocation at all; there is generally no separate investment in the contract to allocate against.
The half of this decision that is not in the Code. The tax treatment below is statutory and applies to everyone. What it costs you to leave is contractual: the surrender-charge schedule and where you sit in it, any guaranteed withdrawal or income rider and what it is actually worth, and the death benefit. Those live in your contract and the annual statement, not in the law, and this site does not guess at them. Ask the issuer in writing for the current surrender value, the remaining surrender period, and the value of every rider — then the statutory side below tells you what the tax does to whatever is left.
Sources
IRC §72(e)(2) and §72(e)(3), quoted verbatim, including the “without regard to any surrender charge” parenthetical in (3)(A)(i). Retrieved from the United States Code, July 2026.
This states what the cited authority says about a non-qualified annuity — one bought with after-tax money outside a retirement plan — unless a page says otherwise. It is not tax, legal or investment advice. An annuity held inside an IRA or a qualified plan is governed by different provisions. This site states no surrender-charge schedule and no rider value, because both are terms of your particular contract rather than rules of law.
Related
Guides › Pension and Annuity Decisions
What leaving actually costs, in your numbers: the surrender calculator takes your own charge schedule and basis and returns the charge, the income tax on the gain, the 10% additional tax if it applies, and what the charge costs in each remaining year — so you can see what waiting is worth.