An annuity is a contract issued by an insurance company and usually referred to as an annuity policy or annuity contract. The investment made into an annuity is referred to as a premium, which is considered as the original contribution. These "earnings", unlike money in a savings account or other investment vehicles are not taxed in the year in which they are earned. Any growth in your annuity accumulates on a tax-deferred basis.

The IRS generally will tax the "earnings" generated from an annuity, upon distribution. Thus, when money is withdrawn from an annuity, the earnings, in accordance with the Tax Code, are considered withdrawn first. These earnings are then subject to the taxpayers "ordinary income tax rates" in the year in which they are withdrawn. Whereas any gain distributions in a mutual fund are taxed at capital gains rates.

Thus, at payout, annuity earnings are treated as ordinary income tax rate and not at the favorable capital gains tax rate.

But, it is also worth noting that the IRS will assess a 10% penalty tax on any premature distribution of an Annuity. This occurs when a taxpayer is aged below 59 ½. In this case, not only are your earnings taxed at ordinary income tax rates, but the IRS will assess a penalty of an additional 10% on the earnings that are taxed. But, as with all IRS tax rules there are exceptions to this rule, where the Taxpayer would avoid paying penalties on the premature distributions. These are as follows;

1.Distributions are made after your 59 1/2.

2.Distributions are made on or after the death of the owner of the annuity.

3.Distributions are made if the taxpayer becomes disabled.

4.Distributions are made as a part of a series of substantially equal periodic payments (not less than annually) for the life (or life expectancy) of the taxpayer or joints lives (or joint expectancies) of the taxpayer and his or her designated beneficiary.

5.Distributions are made under a single premium immediate annuity with a starting date no later than one year from the annuity purchase date.

6.Distributions are made under certain annuities issued in connection with a structured settlement agreements.

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I thought a fixed annuity was tax deferred if you didn't withdraw anything within the taxation year?