What amount of each monthly payment is taxable to Derrick, who is receiving $1,500 monthly from his annuity?

What amount of each monthly payment is taxable to Derrick, who is receiving $1,500 monthly from his annuity?

• A. $1,500
• B. $0
• C. $1,125
• D. $375

Answer: (D)

To determine how much of Derrick's monthly annuity payment is taxable, it’s essential to understand the tax implications of annuities. The taxation of annuity payments depends on a few factors including whether the annuity was purchased with after-tax money or pre-tax funds. In the context of his payments, a portion is considered a return of his investment (the principal he contributed) and is not taxable, while the remainder is earnings (interest) which is taxable. Specifically, when an individual buys an annuity, they pay a certain amount which is known as their "cost basis." The earnings on those funds are subject to income tax upon distribution. For example, if Derrick has a total cost basis of $8,000 in the annuity and is set to receive payments totaling $18,000 over the life of the contract, a calculation needs to be made to determine the taxable amount versus the nontaxable amount. The annuity payment can be taxed on a pro-rata basis. If it is assumed that $1,125 of each payment represents his return of investment and $375 represents the taxable earnings, then the $375 of his payment is the amount that would be included in his taxable income. Thus, he would report $375

To determine how much of Derrick's monthly annuity payment is taxable, it’s essential to understand the tax implications of annuities. The taxation of annuity payments depends on a few factors including whether the annuity was purchased with after-tax money or pre-tax funds.

In the context of his payments, a portion is considered a return of his investment (the principal he contributed) and is not taxable, while the remainder is earnings (interest) which is taxable. Specifically, when an individual buys an annuity, they pay a certain amount which is known as their "cost basis." The earnings on those funds are subject to income tax upon distribution.

For example, if Derrick has a total cost basis of $8,000 in the annuity and is set to receive payments totaling $18,000 over the life of the contract, a calculation needs to be made to determine the taxable amount versus the nontaxable amount. The annuity payment can be taxed on a pro-rata basis.

If it is assumed that $1,125 of each payment represents his return of investment and $375 represents the taxable earnings, then the $375 of his payment is the amount that would be included in his taxable income. Thus, he would report $375