Timing is important when it comes to defining how you're going to take -- and be taxed on -- annuity income. By Kimberly Lankford, Contributing Editor From Kiplinger's Personal Finance, October 2013 The conventional advice is to avoid investing in a deferred annuity within a tax-deferred retirement account because the retirement account already has the benefits of tax deferral. But now that more people are buying annuities for their lifetime income guarantees rather than their tax benefits, investing in immediate or deferred income annuities within retirement accounts is gaining popularity.See Also: Add an Annuity to Your Retirement Mix Taxable annuity payouts are always taxed at your ordinary income tax rate—not the lower capital gains rates. If your annuity is in a traditional IRA, 401(k) or retirement account in which all of your contributions were pretax or tax-deductible, all of the payouts will be taxed as ordinary income. (If the annuity is in a Roth IRA, all of the withdrawals will be tax-free as long as you’ve had the Roth for five years and are over 59½.) If you have a deferred-income annuity in a tax-deferred retirement plan and have to take required minimum distributions at age 70½, you may not be able to defer payouts past that age. If you invested after-tax money in the annuity, the way you take the money can make a big difference. If you have an immediate annuity or if you choose to convert a deferred annuity into a lifetime income stream (called “annuitizing”), then a portion of each payout is considered to be a tax-free return of principal and a portion is taxable earnings. The principal is returned in equal tax-free installments over the payout period. If you have a life annuity with payouts that stop when you die, for example, then the payout period is the IRS’s life-expectancy number for someone your age. Divide your contributions by that life-expectancy number, and you’ll owe taxes only on the portion of each payout beyond that. (If you live longer than the IRS tables anticipate, you’ll owe tax on 100% of each payment after you have recovered your investment.) Advertisement If you take deferred annuity withdrawals on your own, instead of locking in lifetime income, all of the early payouts are considered taxable earnings, and payouts after that are treated as a tax-free return of principal. If you withdraw the money in a lump sum, then you owe taxes on the difference between your original contributions and the amount you receive when you cash out.