Under current federal law, annuities receive special tax treatment. Income tax on annuities is deferred, which means you aren’t taxed on the interest your money earns while it stays in the annuity. Tax-deferred accumulation isn’t the same as tax-free accumulation. An advantage of tax deferral is that the tax bracket you’re in when you receive annuity income payments may be lower than the one you’re in during the accumulation period. You’ll also be earning interest on the amount you would have paid in taxes during the accumulation period. Most states’ tax laws on annuities follow the federal law.
Part of the payments you receive from an annuity will be considered as a return of the premium you’ve paid. You won’t have to pay taxes on that part. Another part of the payments is considered interest you’ve earned. You must pay taxes on the part that is considered interest when you withdraw the money. You may also have to pay a 10% tax penalty if you withdraw the accumulation before age 59 ½. The Internal Revenue Code also has rules about distributions after the death of a contract holder.