When you buy a deferred annuity, the interest credited to your contract builds up
free of current income tax.
Once you start to receive a monthly payment, however, the government begins to tax
the accumulated interest. Part of each payment will be interest and will be taxed
as ordinary income. The other part is principal and is not taxable. This is true
of both deferred and immediate annuities.
If you withdraw money from your annuity before age 59 1/2, the interest you have
earned on your contributions must be withdrawn before the principal and is subject
to personal income tax. In addition, there is a 10 percent penalty tax on such premature
withdrawals, except in certain circumstances, such as disability or death.
You may want to consult a tax advisor well in advance of retirement for more information
about the taxation of retirement income. Also, the Internal Revenue Service has
helpful booklets on the subject.
Most states require insurance companies to pay a tax, commonly at 2 percent, on
the annuity premiums they receive. A company will either charge you for the tax
separately or include it in the premium amount.