When an annuity is paid to an annuitant, he or she receives a portion of the principal and part of the return it has earned. For federal and state income tax purposes, only the amount attributable to the income generated by the principal, not the principal itself, is considered taxable income. The INTERNAL REVENUE CODE provides an exclusion ratio to determine the amount of taxable income paid to the annuitant. Special tax rules apply to annuities that are qualified employee retirement plans.
The annuity payments made to the estate of a decedent might be subject to estate and gift tax as an asset of the decedent's gross estate. Federal and state laws governing estate tax must be consulted to determine the liability for such taxes.