Illinois does tax non-qualified annuity income. The earnings portion of your distribution is subject to the state’s flat 4.95 percent income tax, because non-qualified annuities fall outside the retirement income subtraction that shields 401(k)s, IRAs, and government pensions from Illinois tax.1Illinois General Assembly. Illinois Compiled Statutes 35 ILCS 5/2032Illinois Department of Revenue. Income Tax Rates The subtraction is broad enough that many retirees assume it covers every kind of retirement money, and that assumption is where the surprise tax bill comes from.
Which Part of Your Distribution Illinois Actually Taxes
Illinois builds its tax on top of your federal adjusted gross income, so whatever the IRS treats as taxable flows straight into the Illinois calculation.3Illinois Department of Revenue. Individual Income Tax Every non-qualified annuity distribution has two parts: a return of the after-tax money you originally put in (your basis) and the tax-deferred earnings that grew inside the contract. Only the earnings piece is taxable at either level.
How the two parts get separated depends on how you take the money.
Annuitized Payments
If you annuitize the contract and take regular periodic payments, the IRS applies an exclusion ratio. That ratio compares your investment in the contract to the expected total payout. Put in $100,000, expect $200,000 back, and half of every payment comes out tax-free as return of basis; the other half is taxable earnings.4Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Once your entire basis has been recovered, every dollar after that is fully taxable.
Lump Sums and Partial Withdrawals
Take a partial withdrawal or a lump sum surrender instead, and IRC Section 72(e) applies an earnings-first rule. Earnings come out ahead of basis, not proportionally with it. A $10,000 withdrawal from a contract holding $15,000 of untaxed earnings is fully taxable, because the whole withdrawal sits inside the earnings layer. Only after all accumulated earnings are gone do you start pulling out tax-free basis. This applies to contracts entered into after August 13, 1982.
Whichever method applies, the taxable number lands in Box 2a of the Form 1099-R your insurance company sends, and that figure carries into your federal AGI.5Internal Revenue Service. About Form 1099-R Illinois taxes what federal AGI contains.
Why the Illinois Retirement Subtraction Doesn’t Reach Non-Qualified Annuities
Illinois has one of the most generous retirement income exemptions in the country. No dollar cap, no age requirement, and it removes most federally taxed retirement income from Illinois taxable income entirely. So why doesn’t it cover a non-qualified annuity?
The answer sits in the statute. Section 35 ILCS 5/203(a)(2)(F) limits the subtraction to income included in federal AGI under specific Internal Revenue Code sections: 402(a), 402(c), 403(a), 403(b), 406(a), 407(a), and 408.1Illinois General Assembly. Illinois Compiled Statutes 35 ILCS 5/203 Those sections govern qualified employer plans like 401(k)s and 403(b)s, IRAs, and a handful of related plans. The subtraction also picks up government retirement and disability plans and certain retirement payments to retired partners.
Non-qualified annuity earnings, by contrast, are taxed under IRC Section 72. Section 72 is not in the list. Because the income enters your federal return through a code section the Illinois statute doesn’t reference, the state doesn’t treat it as subtractable retirement income. Illinois Publication 120 makes the point plainly, telling taxpayers they may not subtract “income that is not from a qualified employee benefit plan” and specifically flagging non-government deferred compensation income as excluded.6Illinois Department of Revenue. Publication 120 – Retirement Income
Run the numbers. Withdraw $20,000 from a non-qualified annuity with $15,000 of taxable earnings, and Illinois takes 4.95 percent of the $15,000, or $742.50. Take the same $15,000 out of a traditional IRA, and Illinois takes nothing.
What Illinois Does Exempt, for Contrast
Knowing what qualifies helps confirm what doesn’t. The Illinois subtraction covers the federally taxed portion of:
- Qualified employer plans, including 401(k) and 403(b) accounts
- Traditional IRAs, Roth conversions, and SEP plans
- Federal, state, local, and military pensions and disability plans
- Section 457 state and local government deferred compensation plans
- Railroad retirement income
- The federally taxed portion of Social Security benefits
No income ceiling. No minimum age.7Illinois Department of Revenue. Does Illinois Tax My Pension, Social Security, or Retirement Income? A 45-year-old taking an early IRA distribution still gets the Illinois subtraction on that income, even while owing a federal early withdrawal penalty. The reach of the exemption is precisely what makes the non-qualified annuity gap easy to miss.
Reporting It Correctly on Form IL-1040
Because the taxable earnings already sit in Box 2a of your 1099-R, you don’t recalculate anything for Illinois. That number is already in your federal AGI, which is Line 1 of Form IL-1040.
The retirement subtraction for qualifying plan distributions is claimed on Line 5, with additional subtractions going through Schedule M and totaling on Line 7.8Illinois Department of Revenue. Step 3 – Base Income Non-qualified annuity earnings don’t belong on either line. They stay in your Illinois base income and are taxed at 4.95 percent.
If you receive distributions from both a qualified plan and a non-qualified annuity in the same year, only the qualified plan piece goes on Line 5. Bundling the annuity earnings into that subtraction is one of the quicker ways to draw a notice from the Illinois Department of Revenue.
The Federal Penalty Before Age 59½
On top of income tax, pulling non-qualified annuity earnings before age 59½ triggers a 10 percent federal penalty on the taxable portion. This penalty comes from IRC Section 72(q), which has its own narrower list of exceptions than the more familiar Section 72(t) that governs IRAs and qualified plans.9Office of the Law Revision Counsel. 26 U.S. Code 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts Common exceptions include distributions made after age 59½, after the contract holder’s death, due to total disability, as substantially equal periodic payments, or from an immediate annuity contract.
Notably absent from the 72(q) list: exceptions for first-time home purchases, higher education, medical expenses, and birth or adoption costs. Those live in 72(t) and don’t carry over. If you’re under 59½ and need the funds, substantially equal periodic payments are usually the only practical route around the penalty.
Illinois doesn’t add its own early withdrawal penalty. But the federal 10 percent doesn’t reduce your AGI either, so it doesn’t shrink your Illinois tax. You pay the federal penalty and the Illinois 4.95 percent on the full earnings amount.
Using a 1035 Exchange to Defer Illinois Tax
If the reason you’re looking at a withdrawal is dissatisfaction with the current contract rather than a need for cash, a Section 1035 exchange lets you move to a different annuity without triggering tax. Under IRC Section 1035, a direct insurer-to-insurer transfer between annuity contracts is tax-free.10Office of the Law Revision Counsel. 26 USC 1035 – Certain Exchanges of Insurance Policies The contract owner and annuitant have to match on both sides, and the funds must move directly; a check made out to you breaks the exchange and makes the full gain taxable. Partial exchanges are allowed but carry a 180-day testing period under Rev. Proc. 2011-38, during which a withdrawal from either contract can retroactively convert the transfer into a taxable distribution.11Internal Revenue Service. Rev. Proc. 2011-38
A 1035 exchange delays the Illinois tax; it doesn’t erase it. The new contract is still a non-qualified annuity, so when you eventually take earnings out, Illinois will still tax them at 4.95 percent. What the exchange buys you is time and, if you choose well, better terms on the underlying contract.