If you receive annuity income, you'll probably have to pay tax on at least some of the money. The tax rules depend, in part, on the type of annuity it is. Qualified annuities are set up by employers and generate retirement income the way a 401(k) does. A non-qualified annuity is one you buy yourself, with after-tax dollars.
If your employer pays for your entire qualified annuity without any contributions from you, everything you withdraw is taxable. The same is true if you pay for the annuity by contributing pre-tax dollars to the account, the way you would with a 401(k) or traditional IRA. If your account contributions include after-tax dollars, that part of the annuity is exempt when you withdraw it later. If you paid tax on any of the employer contributions, those withdrawals are also tax-free.
You can't pick whether your withdrawals this month are taxable or tax-free: you have to use the IRS simplified method to calculate your tax. First, calculate how many months you'll receive the annuity based on the IRS tables. Then divide that number into the total taxable contributions you made. If you invested $50,000 after taxes and the tables predict 500 monthly payments, $100 of each payment is tax-free. Everything else is taxable. If you have more than one annuity, apply the method to each annuity separately.
With a non-qualified plan that you buy yourself, all the money you invest is usually after-tax income. That investment is tax-free to withdraw, but the interest on the money is taxable when you take it out. Based on the tables in IRS publication 939, you figure out the ratio of your after-tax contribution to your total expected return. If you spent $120,000 on the annuity, for example, and expect to receive $200,000 in payments, 60 percent of each payment is tax-free.
If your annuity is part of your workplace retirement plan, you pay the same tax penalties for early withdrawal as you do on a 401(k). IRS-authorized withdrawals start at 59 1/2; take money out sooner and you pay a 10 percent tax. At any age, your plan administrator will usually withhold part of the payment to cover your taxes, in the same way that employers calculate withholding on paychecks. You can file a request to dispense with withholding.