How About Taxes?

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If you withdraw money from your annuity before age 59 1/2, the interest you have earned on your contributions must be withdrawn before the principal and is subject to personal income tax.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.