How is each payment under an annuity contract categorized for tax purposes?

Under an annuity contract, payments are categorized for tax purposes as partially taxable. This structure arises from the way annuities are funded and the nature of the returns they provide. When someone pays into an annuity, they contribute a principal amount (the initial investment), which is typically made with after-tax dollars. As the annuity grows, it accumulates earnings or interest, which is considered taxable income.

When payments are made from the annuity, they include both a return of the initial investment (which is not taxable) and a portion that represents the interest or earnings (which is taxable). Therefore, each payment the individual receives consists of a nontaxable component and a taxable component. The portion that is taxable represents the growth, while the nontaxable portion corresponds to the recovery of the original investment.

This mixed tax treatment is a fundamental aspect of annuities, making the understanding of the tax implications essential for individuals who are planning their retirement income strategy. Payments from annuities following this treatment help ensure that individuals are taxed fairly according to their investment and the earnings generated over time.