How are withdrawals from annuities generally taxed?

Withdrawals from annuities are typically taxed as ordinary income, with the earnings portion of the withdrawal being taxed first. This means that any profit earned through the investment within the annuity is subject to income tax upon withdrawal. The rationale for this tax treatment is rooted in the way annuities are structured — contributions are often made with after-tax dollars, allowing the investment to grow tax-deferred. When funds are finally withdrawn, the IRS generally taxes the earnings as ordinary income, while the principal or original investment is returned tax-free.

This approach also prevents the taxation of the initial investment amount, as it has already been taxed when contributed, ensuring that only the appreciation or earnings generated by the annuity are subject to tax. Additionally, this method aligns with the intention behind tax-advantaged investment vehicles like annuities, which is to encourage long-term savings for retirement.

Understanding this tax structure is crucial for individuals planning withdrawals from their annuities, as the tax implications can significantly impact their overall tax liability and financial strategy.