How is the interest paid during an annuity's payout period typically treated for tax purposes?

During an annuity's payout period, the interest earned is generally classified as ordinary income for tax purposes. This means that any distributions received from the annuity, which includes both the return of the principal and the interest earnings, are taxed at the individual's regular income tax rate.

This treatment occurs because the contributions to the annuity were often made with pre-tax dollars, meaning that the tax liability is deferred until the money is withdrawn. Thus, when payouts begin, the interest portion of those payouts is subject to taxation just like wages or salaries.

Understanding this classification is essential for individuals making financial plans, as it can impact their overall tax strategy during retirement. The ordinary income tax treatment highlights the importance of careful planning regarding withdrawals from an annuity, as it may influence the tax bracket for individuals receiving these payments.