When an annuitant enters the payout period and annuitizes the contract the insurance company will spread their cost basis (amount invested) over their lifespan. For example, if an annuitant had invested $50,000 into the annuity (their cost basis) and the annuity account balance was now $100,000 then the annuitant annuitized and was to receive payments of $4,000 per year they would NOT have to pay tax on the first $2,000 they receive each year.
How is this figured? First, divide the total amount ($100,0000) by $4,000 (the annual payments the annuitant will receive) to find out the annuitants projected lifespan (25 years). Then divide their cost basis ($50,000) by 25 years ($2,000). The first $2,000 of payments the annuitant receives each year for the first 25 years is a return of their cost basis and is not taxable. Any amount over the $2,000 they receive each year is taxable as ordinary income. What happens if they live longer than 25 years? The $4,000 per year will continue to be paid but will now be fully taxable since all of their cost basis has been returned to them.