The tax rate on annuities is zero during the accumulation phase; however, annuities are taxable during the distribution phase. The tax rate depends on the final amount that is determined from actuarial models by insurance companies. This final amount is treated as ordinary income and is taxed as such.
There are two types of annuities: deferred and immediate-payment annuities. A deferred annuity offers a tax advantage in that during the accumulation phase, the amount contributed is nontaxable, thus reducing the taxable income of the annuitant. Depending on what proportion of the income is contributed towards the deferred annuity, the taxable income can be significantly reduced. The contributions earn tax-free compound interest, resulting in significant tax savings. Since the annuity amount paid out regularly is often less than the contributor's income during working days, there is less tax to pay.
With immediate-payment annuities, the annuitant contributes a lump sum and immediately starts receiving regular payments for the rest of his life. The amount is determined from actuarial models used by insurance companies. This amount is divided into two portions: the principal and the interest. If the lump sum was already taxed, the principal portion of the annuity will be tax free, but the interest will be taxable. If the lump sum had not been taxed yet, then the whole annuity is taxable.