Annuities allow individuals to set money aside for the future and enjoy tax-deferred growth. When an annuity owner settles for a lifetime stream of payments, the Internal Revenue Service expects to get its share of the taxable portion as the money comes out. Annuities, unless set up as a qualified pre-tax plan like an IRA, are funded by regular income. Since annuity owners already paid taxes on the money they used to fund the annuities, only the growth is considered taxable gain.
Determine your cost basis. Find the sum of all deposits you made into the annuity. For example, if you deposited $1,000 a year for five years, your cost basis in the annuity is $5,000.
Divide your cost basis by the accumulation value. The result is your exclusion ratio. For example, if you deposited $5,000 into an annuity and its accumulation value is $10,000, then your exclusion ratio is 50 percent.
Multiply the size of your monthly payout by the exclusion ratio. The product is the portion of your payout that is excluded from taxation. For example, if your exclusion ratio is 50 percent and your monthly payments are $300, then $150 are excluded from taxation as a return of investment.
Subtract the excluded portion from the total monthly payout to determine the taxable portion. For example, if the excluded portion of your $300 payment is $150, then your taxable portion is $150.
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