An annuity is a systematic liquidation of principal and interest over a fixed or contingent period of time. Thus, the term annuity includes payments for a fixed period or payments of a fixed amount in addition to payments lasting for one or more lives. Payments of interest only will not qualify for annuity taxation because there is no liquidation of principal.
Amounts received as an annuity are taxed under special rules that allow the annuitant to exclude from tax a fixed (return of cost) portion of each payment from gross income each year and require the payment of income tax at ordinary rates on the balance of each payment. Stated in another manner, a fixed portion of each payment received can be excluded from income as a return of capital while the balance of each payment is reportable as taxable income. Annuities for a complete discussion of these taxation rules.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM