Arizona Life and Health Practice Exam

The interest paid during an annuity's payout period is considered?

1. Tax-exempt income

2. Taxable as ordinary income

3. Capital gains

4. Deferred income

The correct answer is: Taxable as ordinary income

During the payout period of an annuity, the earnings or interest that accumulate within the annuity are taxed as ordinary income when they are distributed to the annuitant. This is because annuities are designed to provide regular payments over time, and the earnings portion of these payments is considered income by the Internal Revenue Service (IRS). When an annuity is funded, contributions (known as premiums) are made with after-tax dollars, meaning that tax has already been paid on those contributions. However, the investment growth or interest that accumulates in the annuity is tax-deferred until it is withdrawn. Therefore, when payments begin, the portion of the payment that represents earnings is taxed at ordinary income tax rates, while the portion that represents the return of principal is not subject to further tax. This framework distinguishes the treatment of annuity payouts from other income types, such as capital gains, which are taxed differently, or tax-exempt income, which is not subject to taxation at all. Understanding that the interest or growth from an annuity is taxed as ordinary income is crucial for proper tax planning and financial strategy.