Your Fixed Annuity Payments

A fixed life annuity ensures you a guaranteed income during your retirement years. Obviously, the amount of income depends on how much an individual contributes to the annuity -- and how much the account has grown. Income options include a month to month payout based only on a single life, or in the case of a married couple, a joint life option - or simply a fixed (certain) term. But how are annuity payments taxed?

We're going to deal with a non qualified annuity here. Their tax-benefit is the tax-deferred growth of your investment within the contract until you take money out. While many people use non qualified annuities as a retirement tool, unlike a traditional IRA, it is funded by your after-tax contributions. Each annuity payment that corresponds to this original investment is not taxable to you.

Since the contributions you make on the non qualified annuity are already taxed, they will not be taxed afterwards as you withdraw your cash. They constitute the 'basis' of one's investment in the annuity contract. You recover this original investment as a non-taxable portion of each of the annuity payments.

When you have chosen your monthly payout option, the term you have selected for payments, your age and the amount of payments, will determine how much of each payment is taxable and how much is tax free.

Taxation of annuity payments -- term certain option

When the period of time for payouts are fixed (i.e. a term certain such as 10 years), you know there wil be exactly 120 payments. You simply divide the complete number of months into your 'basis'; which gives you how much of each monthly annuity payment is tax free. The rest of the monthly annuity payment will be taxed at ordinary income rates.

Taxation of annuity payments -- life option

In this case, you utilize your life expectancy - at the outset of your distributions - the number of years over which your capital will be returned to you - in the same way if it were a term certain situation. For example, a 70-year-old has an estimated life expectancy of 192 months. So you divide 192 into your original investment and that is the portion of each payment that is non-taxable. The remainder of the annuity payment will be be subject to annuity tax at your ordinary income rate.

What if a person outlives the estimated life expectancy?

If you outlive your life expectancy (not always a bad thing!) used in determining your portion of tax free annuity payments above, then your original contribution will have been fully recovered. All future annuity payments are then 100% taxable.

For those of you who began your annuity payouts before 1988, you can continue to maintain the same percentage of payout as non-taxable as when you started regardless of how long you live.