How are funds received from an annuity taxed for the receiver?

When an individual receives funds from an annuity, the tax treatment is governed by the exclusion ratio, which allows for a portion of the annuity payments to be received tax-free. This ratio is calculated based on the total investment in the annuity compared to the expected return from the annuity.

For individuals who have contributed to the annuity with after-tax dollars, the portion of each payment that represents a return of principal (or the investment) is not taxed again. Only the earnings portion of the annuity payout is subject to taxation when received. This method of determining tax liability is designed to ensure that individuals are only taxed on the gains they earn from their investment in the annuity, making it a fair approach to tax treatment.

In contrast, if an annuity were considered fully taxable, it would mean the entire amount received would be subject to income tax, which does not reflect the fact that part of that amount represents a recovery of the initial investment. Similarly, non-taxable treatment would imply that none of the funds received would be subject to tax, which ignores the earnings generated. The option stating "taxed only on gains" oversimplifies the process and does not reflect the involvement of the exclusion ratio in defining how annuity payouts are