Annuities can be a great way for retirees to receive guaranteed income for life. But you may not be able to keep all the money you receive from an annuity because the IRS may demand a cut. Whether or not your payments are taxable will depend on how you paid for the annuity.

Through a tax-deferred retirement account

If you use pre-tax money (including money from a traditional IRA or 401(k) that you didn't pay taxes on) to buy an annuity, then the annuity payments are fully taxable as income. For example, say you used some of the money in your 401(k) to buy an annuity that will pay you $2,000 per month. When you prepare your tax return, you'll have to include that $24,000 in annual payments as income and pay taxes on it.

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Purchased with taxable income

If you bought your annuity with post-tax dollars, meaning money that you declared on your tax return and paid income taxes on, then your annuity payments will be partially taxable. The percentage of the payment that's considered a return on your initial investment will not be taxable; the rest, which is your gain on the investment, will be taxed.

Calculating your basis

To figure out how much of your annuity payments are taxable, you first need to figure out how much you've invested in the annuity. The IRS calls this amount your "basis." Your basis in the annuity is the total amount you spent on premiums and contributions using post-tax money, minus any tax-free money that you got back (refunded premiums, rebates, dividends, etc.) before your annuity payments started coming in.

Expected return

Once you know what your basis is, the next step is to calculate your expected return. For a period annuity (an annuity that pays you for a certain number of years, instead of for the rest of your life), the expected return will be the number of months in the payment period times the amount of the monthly payment. For example, if you'll be getting payments for 60 months and the annuity pays $5,000 per month, your expected return would be $300,000.

Lifetime annuities are a bit more complicated. No one knows exactly how long you're going to live, but actuaries like to come up with figures that represent your probable lifespan. To calculate your expected return, you look up the number that represents your anticipated lifespan in the IRS's actuarial tables, then multiply that number by the amount that the annuity pays you every year. For example, let's say your annuity pays you $12,000 per year and the actuarial table lists your anticipated lifespan as 20.5 years. Multiply $12,000 by 20.5 to get an expected return of $246,000.

Some annuities are "shorter of life or period," meaning that they will pay out either for a set number of years or until you die, whichever comes first. In that case, you calculate the expected return using a different actuarial table provided by the IRS. The calculation method is the same as the one you use to figure expected return for a lifetime annuity.

Exclusion percentage

Now that you have both your basis and your expected return, you're ready to figure out how your annuity payments will be taxed. Simply divide your basis by your expected return, and the result is the percentage of each annuity payment that will not be taxable. Then multiply that percentage times the amount of the payment to get a dollar figure.

For example, let's say that your basis in your fixed lifetime annuity is $300,000, and your expected return is $400,000. $300,000 divided by $400,000 gives you a result of .75, or 75%. That means that 75% of each annuity payment you receive is not taxable. So if your annuity pays you $4,000 per month, you'd multiply $4,000 by .75 and discover that $3,000 of each payment you receive is not taxable and the remaining $1,000 is taxable.

Variable annuities: a special case

With variable annuities, your monthly payment can vary over time, sometimes by quite a large amount. That means that the amount of taxable income you'll receive from the annuity will vary as well.

To figure out your taxable versus tax-free payments, you calculate the basis using the same method as for fixed annuities. Divide your basis by the number of payments you expect to receive from the annuity (if it's a lifetime annuity, use the IRS's actuarial tables to identify this number). The result is the dollar amount of each payment that will be tax-free.

For example, if your basis in the annuity is $30,000 and you'll be receiving 60 payments, then you divide $30,000 by 60 for a result of $500. That means the first $500 of each payment you receive is not taxable.

Taxation complications

Certain factors can make calculating your annuity's taxable portion a lot more complicated. For example, if the amount you receive from a variable annuity is less than the tax-free amount you calculated, you can redo the calculation to apply the missed tax-free amount to future payments. And if you purchased survivor benefits on an annuity, figuring out the taxable portion of those benefits can get rather messy. In these cases, it's generally best to turn to a tax professional for help. You really don't want to find out about your math error from an IRS auditor.