What portion of annuity benefit payments is subject to income taxation?

The portion of annuity benefit payments that is subject to income taxation is the portion representing interest earned on the declining principal. This is because annuities operate under a tax-deferred growth structure. During the accumulation phase, the funds grow tax-free, but once payments begin during the annuitization phase, the IRS requires that the interest earnings on the principal be taxed as ordinary income.

When an annuitant receives payments, initially there may be a component that represents the return of the principal, which is not taxable because it is essentially a return of the individual's own investment. Conversely, any income accrued from that investment—that is, the interest earned—is taxable when distributed. Therefore, as payment continues, only the part that exceeds the return of the principal is considered taxable income.

While options that suggest the entire payment amount or only the return of principal could be considered, they do not accurately reflect the tax treatment provided under IRS guidelines. Similarly, payments made after the annuitant's death generally create a different tax situation and are not related to the taxation of benefit payments during the annuitant's life.