The Unfair Taxation of Annuities
Note: What follows is purely a matter of opinion. If you don't want to hear my opinion return to the annuities page and make up you own mind.

Annuities are an insurance instrument that pay as long as the annuitant is alive. They are intended to protect the annuitant against outliving their money. There is a public good in annuities; they are a useful private investment that can prevent the annuitant from become a ward of the state. This is the primary reason why tax on the interest earned in an annuity is deferred.

Once the annuity begins payments any money that has already been taxed is amortized over the life expectancy of the annuitant and a portion of each payment is excluded from tax. After the life expectancy is reached the excluded amounts will have accumulated to be equal to the amount already taxed so the exclusion is turned off and the payments become fully taxable. The annuitant suddenly finds their tax liability increasing, often at a time when medical costs are also sharply rising.

This increased tax on the elderly is onerous. But usually anyone paying a tax considers it onerous. Being onerous doesn't necessarily make it unfair. Unfair would be if there were different tax treatment for people in the same situation. Can we call this unfair?

Yes! Because the annuity is insurance against living too long all payments made before the end of the life expectancy are really just withdrawals from an investment and all payments made after the life expectancy are really claims on the insurance portion of the product. Any other insurance claim (Life, health, auto, fire) is non-taxable.

But, some would argue, fire insurance exists to replace something built with money that was already taxed. My response is that Life insurance is paid, tax free, although the money certainly isn't used to bring the deceased back to life. It is simply income that the beneficiary can use to offset money that WOULD have been provided to the beneficiary by their deceased caretaker. Materially the situation isn't any different.

So what WOULD be fair? At first glance the answer would seem to be to make the ENTIRE payment non-taxable (after the life expectancy is reached).

There is the danger, though, of the very wealthy using this as a means to avoid taxes. Clearly someone with sufficient wealth to live completely off the interest of their investments is never in any danger of becoming a ward of the state. They don't need insurance against outliving their resources. Perhaps a fair compromise then would be to make all post-life-expectancy payments non-taxable up to the amount equal to the average cost of living in the US.

Of course by such logic then life insurance should only be taxable up to the average cost of caring for ones beneficiaries. Consider that a topic for others to take up.