How are annuity payments categorized for tax purposes?

Annuity payments are categorized for tax purposes as a combination of taxable and non-taxable amounts. This arises from the fact that annuities are often funded through a combination of after-tax contributions and interest earnings. When an individual receives annuity payments, a portion of each payment is considered a return of the initial investment (which is not taxable) and the remainder is the earnings on that investment (which is taxable).

The IRS uses an "exclusion ratio" to determine the taxable and non-taxable portions of an annuity payment. The exclusion ratio is calculated based on the total amount invested in the annuity compared to the expected total return. This means as the annuitant receives payments, some of the amount is treated as a recovery of basis (the amount contributed) and is therefore not subject to tax, while the rest, representing the earnings, is taxable.

This understanding aligns perfectly with how the tax system recognizes the nature of annuities and helps taxpayers accurately report their income from these payments.