How are annuity payments taxed when received?

When annuity payments are received, they are taxed based on an exclusion ratio, which is a method of determining the portion of each payment that is considered a return of principal versus the portion that is treated as taxable income.

In essence, when an individual purchases an annuity, a portion of their investment is returned to them when they start receiving payments. This portion is considered a return of principal and is not subject to taxation. The remaining portion of each payment typically consists of earnings or interest, which is taxable as ordinary income. The exclusion ratio is calculated based on the amount invested in the annuity relative to the total expected payments over the annuity's life.

This taxation method allows annuity owners to avoid taxation on the initial investment amount while recognizing tax obligations on the earnings as they are distributed. This mixed approach to taxation aligns with the principles of how annuities function as investment vehicles, ensuring that the return of principal is not double-taxed while still requiring tax on the income earned.