Getting the most value from any annuity arrangement begins with an understanding of the relevant income tax rules. This helps us to understand how much income taxes will be taken from our annuity payments during retirement. This article will discuss some important tax rules you need to be aware of with respect to annuities. 

The income tax rules that apply to all annuity payments start with Section 72(b) of the Internal Revenue Code (‘Code”). This rule begins with the idea that every person should be allowed to recover his or her own contributions to a non-qualified annuity free of tax. This makes perfect sense, as your own non-qualified contributions were paid for with after-tax money. Your personal investment in a non-qualified annuity is commonly referred to as your cost basis.

The Code allows you to recover your cost basis gradually over the time you are receiving annuity payments. So, out of each payment received by you, a portion will represent a tax-free return of your bask. The amount of the payment that exceeds the basis portion is subject to federal income taxes at your respective tax rate. This will range anywhere from 10 to 35%. depending on your income level during your retirement years.

To understand how this works, lets look at an example. First, lets assume that our annuity owner, who is a non-smoking 60-year-old male and in good health, invests $250,000 of his own funds into a fixed deferred annuity that will start making income payments to him for the rest of his life when he turns 65. Lets assume that this, taxpayer will pay income taxes at a 15% marginal rate when he retires.¹ Let’s also assume that the annuity payments in our example come to $2,164 based on the accumulated value of $304,000 when the annuity owner starts taking payments.² Now we have enough information to determine the federal income tax on the annuity.

Looking at the life expectancy tables published by the Internal Revenue Service, we would see that the life expectancy established by these tables for a 65-year old male is 85 years of age. Based upon the initial investment. annuity payment, and life expectancy, the annuity owner will be allowed to exclude $1,042 of each annuity payment from income taxation.³ Once we apply the 15% rate to the remaining portion of the payment, we come up with a federal income tax of $168 for each annuity payment^.4  Here's a breakdown of how the excluded part of the annuity payment was calculated:

Investment In Contract
($250,000)
--------------------------  x Payment ($2,164) = $1,042 Excluded Amount
Expected Payment over Life
($2,164 x l2mo x 20yr)
 

------------------
1. Married couples filing joint returns are taxed on the first $65,100 if their taxable income at the lower 10%  and 15% rates (2008 IRS tax tables). 

2 American National Life, assumes 4% during deferral period and life payout based on January 2007 monthly  rates of $7.12 per $1000, male age 65.

3 Reg. 1.72-9 (Table V) 

4 ($1122 multiplied by 15% tax rate)