Question

Explain how annuity distributions are taxed.

Answer 1

Annuity distributions are taxed based on what money had been used for investing in.

if you use pretax money from an IRA or a 401(k) to purchase the annuity, then all payouts will be fully taxed. If you use after-tax dollars to buy the annuity, however, then a portion of the payouts will be a tax-free return of your principal. Either way, you'll have to pay any taxes that you owe on the annuity at your ordinary income-tax rate, not the preferable capital-gains rate.

Taxability also depends on the type of annuity,

1. Immediate annuity, The money you invested in the immediate annuity is returned in equal tax-free installments over the payment period. If you have a life annuity with payouts that will stop when you die, for example, then that payment period is the IRS's life-expectancy number for someone your age. You'll owe taxes only on any portion of each payout beyond the tax-free return of principal
2. Deffered annuity, in deferred annuity the taxability will arise at the time of withdrawal from the annuity.