How annuities are taxed in North Carolina

If you are a retiree or getting close to retirement in Cary, Apex, or anywhere in the Triangle, you may be wondering how annuity income will affect your tax bill. The short answer: it depends on how the annuity was funded, how you take money out, and whether the IRS treats it as qualified or nonqualified. North Carolina generally taxes annuity income at its flat state rate, but the details matter.

This guide walks through the federal and North Carolina rules, explains where exceptions exist, and gives you a framework for questions to bring to a licensed tax professional.

What to know first

A few basics before the details:

• Not all annuity income is fully taxable. If you used after-tax dollars to buy the annuity, part of each payment may be a tax-free return of your original cost.
• Federal rules drive the taxable amount. North Carolina then uses that federal taxable amount to determine your state tax.
• NC taxes the taxable portion of annuity payments at a flat rate of 3.99% for 2026. There is no broad state exemption for private annuity income.
• The answer changes depending on the type of annuity, the payout method, your age, and your contract terms. Generic rules do not replace a review of your specific situation.

How annuity taxation works at a high level

Annuities receive different tax treatment depending on two main factors: whether the money went in pre-tax or after-tax, and how it comes out.

Qualified annuities are held inside a retirement account like an IRA or 401(k). The contributions were pre-tax (or tax-deductible), so the entire withdrawal or payment is generally taxable as ordinary income when it comes out. The annuity is essentially a wrapper around the retirement account, and the tax rules follow the account.

Nonqualified annuities were purchased with after-tax money. This is where tax treatment gets more nuanced. The earnings inside the annuity grow tax-deferred, and when you take payments, the IRS splits each payment into a tax-free return of your cost basis and a taxable earnings portion.

The distinction between these two categories is one of the first things a tax professional will want to know. If you are not sure which type you hold, look at how the annuity was funded and check your contract.

Federal tax rules for annuity income

Tax deferral during the accumulation phase

For nonqualified annuities, earnings inside the contract grow tax-deferred. You do not owe federal income tax on interest or gains while they remain inside the annuity. This is different from a regular savings account or CD, where interest is taxed the year it is earned.

This deferral is one reason people consider annuities. But it comes with trade-offs, including surrender charges if you withdraw early and a 10% IRS penalty on earnings taken before age 59 and a half (there are exceptions, so ask your tax professional).

How annuitized payments are taxed

Once you begin receiving regular payments from a nonqualified annuity (a process called annuitization), the IRS uses what it calls the General Rule (described in IRS Publication 939 ) to figure out what portion of each payment is tax-free.

The mechanics work like this:

• Your net cost (total premiums paid minus any tax-free amounts already received) is divided by the expected return (annual payment amount times the expected number of payments, based on IRS actuarial tables).
• This gives you an exclusion ratio , expressed as a percentage.
• That percentage of each payment is tax-free return of your cost. The rest is taxable ordinary income.

For example, if your exclusion ratio works out to 65%, then 65% of each monthly payment would be tax-free and 35% would be taxable. This ratio stays the same for the duration of the payout period, or until your cost basis is fully recovered, whichever comes first.

For annuities from employer retirement plans (qualified annuities), a different calculation called the Simplified Method applies. IRS Publication 575 covers those rules.

Your insurance company or plan administrator typically provides the exclusion ratio on your 1099-R form or in year-end tax reporting. You do not have to calculate it yourself, but it helps to understand what the numbers mean.

Lump-sum and nonperiodic withdrawals

If you take money out of a nonqualified annuity as a lump sum or a withdrawal that is not annuitized, the IRS generally treats the earnings portion as coming out first . This is sometimes described as gains-first or LIFO (last in, first out) treatment. You pay tax on the growth before you touch your original cost basis.

This is worth planning for. A large withdrawal could push you into a higher federal tax bracket in the year you take it, even from a nonqualified annuity. Federal estimated tax penalties can also apply if you do not have enough withheld during the year.

Death benefits

When a nonqualified annuity owner passes away, the beneficiary generally owes federal income tax on the earnings portion of any death benefit. Unlike some other assets, annuities do not get a step-up in tax basis at death. The original cost basis carries over, and the growth that accumulated during the owner's lifetime is taxable to the beneficiary.

For qualified annuities, the taxation depends on the type of retirement account and the beneficiary's relationship to the deceased. Spousal beneficiaries may have different options than non-spousal beneficiaries. The SECURE Act's 10-year distribution rules also apply to many inherited retirement accounts. These details are contract-specific and worth reviewing with a professional.

North Carolina tax treatment of annuity income

North Carolina uses your federal adjusted gross income as the starting point for your state return. For most retirees receiving payments from private or commercial annuities, the state taxes the federal taxable portion at a flat rate of 3.99%. This rate is set for tax year 2026 per Session Law 2023-134.

Here is what does and does not get special treatment under North Carolina rules:

• Social Security benefits are fully exempt from North Carolina state tax. The entire taxable portion (as determined federally) is subtracted on your state return. This is a meaningful difference from annuity income and one of the clearer advantages of filing in NC.
• The Bailey settlement allows certain retirees who worked for the state of North Carolina or qualifying local government employers and had pre-1989 service to deduct some retirement income. This exemption is narrow. It does not apply to private annuities, most 403(b) plans, or typical commercial annuity contracts sold by insurance companies.
• There is no general North Carolina tax break for annuity income. If your annuity payment is taxable on your federal return, it is also taxable on your NC return.

North Carolina does offer a standard deduction that may offset some of the overall tax burden. The NC D-400 instructions explain how retirement income is treated on your state return, and the NC-4P form is available if you want to have state income tax withheld from annuity or pension payments. Both are available from the NC Department of Revenue.

How annuity taxation compares to other income sources

Understanding how annuities are taxed is more useful when you compare them to other income you may be receiving in retirement:

• CDs and savings accounts: Interest is taxed in the year it is earned, both federally and in NC. Annuities allow tax deferral during accumulation, which CDs do not. But CDs are FDIC-insured, and annuities are not.
• Traditional IRA and 401(k) withdrawals: Fully taxable as ordinary income in most cases, similar to qualified annuities. Tax deferral was already received on the contributions.
• Social Security: North Carolina fully exempts taxable Social Security income from the state return. Annuity income does not receive this exemption.
• Roth IRA withdrawals: Generally tax-free if requirements are met. Roth accounts have a different tax structure entirely.

None of these comparisons tells you which is better for your situation. They each serve different purposes, and the right mix depends on your income needs, tax situation, and the specifics of each account or contract.

What can change your tax picture

Annuity taxation is not one-size-fits-all. These variables can shift the outcome:

• Qualified vs. nonqualified status: This is the starting point for everything else.
• Payout method: Annuitized payments use the exclusion ratio. Lump sums and withdrawals are often taxed on gains first.
• Contract terms: Some annuities include riders or features that affect payouts and may affect taxes.
• When you take money out: Withdrawals before age 59 and a half may face a 10% federal penalty on earnings, with some exceptions.
• Your other income: Large annuity withdrawals can push you into a higher federal bracket or affect Medicare premium surcharges (sometimes called IRMAA). NC's flat rate means no bracket concerns at the state level, but federal bracket management still matters.
• Filing status and deductions: Standard deduction amounts, age-based deductions, and other adjustments all interact.
• Future tax law changes: Federal and state tax rules can change. The 2026 NC rate is set by current law, but future sessions of the General Assembly could adjust it, and federal tax provisions are also subject to revision.

Questions to ask a licensed tax professional

Before making decisions about an annuity, consider bringing these questions to a tax professional who can review your specific situation:

• Is my annuity qualified or nonqualified? What about this specific contract?
• What is the exclusion ratio for my annuity payments, and how was it calculated?
• If I take a lump sum instead of annuitizing, how will the taxes differ?
• How will my annuity income interact with my Social Security and other retirement income for both federal and NC taxes?
• Are there any Bailey or other NC-specific deductions that might apply to my situation?
• How could a large withdrawal affect my federal bracket or Medicare IRMAA surcharges?
• What happens tax-wise if I leave the annuity to my spouse versus another beneficiary?
• Should I have NC income tax withheld from my annuity payments using Form NC-4P?

Where to verify details for your situation

Tax rules change and individual situations vary. These are the most reliable sources for checking the current rules:

• IRS Publication 939 (General Rule for Pensions and Annuities) covers the exclusion ratio for nonqualified annuities. Available at irs.gov/publications/p939.
• IRS Publication 575 (Pension and Annuity Income) covers qualified annuities, the Simplified Method, and nonperiodic distributions. Available at irs.gov/publications/p575.
• NC Department of Revenue : the D-400 instructions and Schedule S explain how retirement income is handled on your North Carolina return. Visit ncdor.gov.
• NC Department of Insurance : oversees annuity sales and consumer protections in the state. Tax rules are handled by the IRS and NC DOR, not the Department of Insurance, but the DOI can help with contract and agent questions. The NC DOI site is at ncdoi.gov.

Putting the pieces together

Annuity taxation touches both federal and state rules, and the details depend on your contract, your other income, and how you choose to receive payments. For Cary and Triangle retirees, the starting point is understanding federal treatment, then layering on North Carolina's flat 3.99% rate and its limited exemptions.

Getting the details right starts with understanding the mechanics. Then you can verify the specifics that apply to you.

If you want to learn more about how annuities work, visit the annuities guide collection for plain-English explanations of fixed annuities, immediate annuities, contract details, and more, or the guide on how fixed annuities work. If you have a general question about annuity taxation or want to know what to ask before meeting with a professional, you can ask a question here.