How are annuity payments taxed?
This is an incredibly complex question. The simple answer is that money from an annuity that hasn’t already been taxed is treated as ordinary income and is reported to the IRS on a 1099 by the insurance company. The complexity arises from the question of what has already been taxed. If you buy the annuity using a direct rollover from a qualified retirement account like an IRA, TSA, or 401(k) then the entire payment is taxed. If, however, the annuity is purchased with cash or if its value builds up in a deferred state over time then every payment has a portion that recovers the cost basis. The Cost Basis is the amount of the purchase price that has already been taxed. The portion excluded from tax is called the exclusion ratio. As each payment is made the excluded amount is accumulated. When the accumulated exclusion catches up to the cost basis the exclusion stops and the payments become fully taxable (Note that there is one payment that “crosses over” that has only a partial exclusion
