One of the most compelling features that entice investors to annuities is their tax-deferred growth benefit. As long as the money remains invested in the annuity, there is no current tax on the earnings. Annuities are taxed, but not until money is withdrawn.

A deferred annuity has two phases, the accumulation phase and the distribution phase. During the accumulation phase, the annuity grows untaxed through the years as the investment compounds. During the distribution phase, the investor receives the proceeds of the annuity, including the earning's growth. The payment may be made as a lump sum or a series of scheduled payouts over a specific period or for a lifetime.

No matter the method of payout, income taxes are charged. If the payment is made as a lump sum, then income taxes will be due on the difference between the amount paid into that annuity and its value when it is paid back. If the payout is a regular series of payments, then each annuity payment is taxed.

If an investor receives the annuity in one lump payout, taxes are paid on the accumulated earnings. These earnings are treated as an investment gain. Annuities gains are taxed as ordinary income, so the taxes paid are computed based on the ordinary income tax rates in effect during the distribution year. Currently, in a traditional life annuity, there are no capital gains tax breaks for these accumulated earnings.

When an investor receives a series of scheduled payments instead of a lump sum, part of each payment is considered a return of previously taxed principal and part of each payment is treated as earnings. The investor owes income taxes on the part of the payment considered earnings. The amount of each payment that isn't taxed is computed by establishing an exclusion ratio, calculated by dividing the investment principal paid for the contract by the total amount expected during the payout period.

Taxes on a variable annuity are calculated differently. With a variable annuity, it is impossible to know the amount of each scheduled payment because the market determines the annuity's value, which changes daily. To compensate for this variability, the excludable amount of each annuity payment is determined by dividing the initial investment by the number of years over which the annuity is expected. The remainder of each payment is declared and taxed as income for that year.

A withdrawal is any distributed amount that is not part of the scheduled annuitization payments. Taxes are based on when the annuity was purchased. Investments made after August 13, 1982, are taxed on a last-in, first-out basis. The first money withdrawn from the annuity is treated as earnings, not principal, and is taxed as ordinary income. Also, like a traditional IRA, withdrawals before age 59.5 are penalized 10%.

If the annuitant dies prior to receiving payments, the annuity passes on to the beneficiaries. When payments are made, the beneficiaries are taxed at ordinary income tax rates. If the annuity contract had been annuitized, then there may or may not be an income tax impact. If the annuitant opted for a life only annuity then nothing passes to heirs and no taxes are due. If the annuitant selected a term-certain option and died before that period elapsed, then the recipient pays taxes on any remaining distributions. A joint-life annuitant continues receiving an income tax exclusion until the entire investment is recovered.

Popular sources of gifting and income, a charitable gift annuity is a simple, contractual agreement between a donor and institution in which assets are transferred in exchange for regular, life-long payments. If the donor itemizes deductions on a tax return, savings from the charitable deduction reduce the net cost of the gift. For a period of years, based on a government table of life expectancies, a portion of each payment received is considered a nontaxable return of your investment in the gift. This further increases the after-tax dollars available for spending or investing.

For more information, read IRS Publication 939, General Rule for Pensions and Annuities, which explains the details on how to calculate taxes on annuity payments.