What tax treatment applies to the payments Irma will receive from her deferred fixed annuity?

The payments Irma will receive from her deferred fixed annuity are generally treated as a return of principal and interest. In the case of annuities, the earnings or interest component is taxed as ordinary income when distributions are taken, while the portion that represents the initial principal is not subject to tax until the investment is fully recovered.

When an individual begins to receive payments from a deferred fixed annuity, their contributions (the principal) have already been made with after-tax dollars. Consequently, they do not face taxes on the return of this principal portion. Instead, taxes are only applied to the interest or earnings that have accumulated within the annuity.

Understanding this treatment is crucial for planning purposes, as it affects the planning for withdrawals and understanding the tax liabilities associated with annuity payments over time. Therefore, the assertion that payments are tax-free until the investment is recovered appropriately reflects how the tax code handles the return of principal in relation to annuity payments.