Annuities are long-term savings products that provide tax deferral during the accumulation phase: initial purchase to distribution. When an annuitant reaches the point when income is desired, an annuity might provide tax-favored income as well, through various income strategies and with what is known as an “exclusion allowance.” When considering the exclusion allowance, it is helpful to know which annuities and income strategies qualify for the allowance and which don’t.
Classification of Annuities
There are two classes of annuities: qualified and non-qualified. A qualified annuity is used in a tax-deductible plan such as an individual retirement account. Non-qualified annuities are those purchased with after-tax dollars.
Because the money in qualified annuities has never been taxed, the income distributed from them is fully taxable and the tax exclusion allowance on the income is not available.
Income from non-qualified annuities enjoys the exclusion allowance. Our focus is on the non-qualified annuity.
Types of Income
An annuitant may elect to take income via withdrawals from the annuity. Under IRS rules, any withdrawal distribution is treated as receiving interest earnings first and principal second. To the extent that there are interest earnings, the withdrawal are fully taxable; no exclusion allowance applies.
Alternatively, an annuitant may elect to take income in one of the methods defined in the contract: life income, which is income for the life of the annuitant; life and period certain, which is income for the life of the annuitant or to a named beneficiary for the remainder of a number of years (the certain period) should the annuitant die before the end of the certain period; or period certain, which is income for a defined number of years, to name a few. These incomes would enjoy the tax exclusion allowance.
Tax Exclusion Allowance
The exclusion allowance or exclusion ratio can be defined as “the portion of an annuitized payment that is a return of capital and therefore not taxed." The exclusion ratio is determined by the type of income payout and the expected return over the lifetime of the payout, by dividing the investment in the contract by the expected return. This ratio is then applied to each income payment to determine the amount that is a return of principal and not included in gross income. The remainder is fully taxable.
Joe Annuitant, 65, has purchased an annuity with a premium of $100,000 and will take income immediately on a life income option. The monthly income he will receive is $600. IRS Table V indicates his life expectancy is 20 years. The expected return from the contract is $144,000 ($600 X 12 X 20). His exclusion ratio would be $100,000/$144,000 = 69.4 percent.
Joe would exclude from income $416.40 of each monthly payment. His taxable income for a full calendar year from his annuity would be $2,203.20 ($600 - $416.40 = $183.60 X 12 = $2,203.20). The exclusion ratio would be applied to all payments in the future.
Internal Revenue Code Section 72 states that annuity income payouts beginning after Dec. 31, 1986, will have the exclusion ratio applied only until the entire investment in the contract is returned. After that, the income payments become fully taxable. In Joe’s case his exclusion ratio would run out at the end of year 20. Income thereafter would be fully taxable.
- 1 Getting Started in Annuities, G. Williamson, John Wiley & Co, 1999
- The Annuity Handbook, D. Chandler, The National Underwriter Co, 1994
- Tax Facts, The National Underwriter Company
- Internal Revenue Code Section 72
- FINRA. "Fixed Annuities." Accessed June 6, 2020.
- Insurance Information Institute. "What Is a Lifetime Annuity?" Accessed June 6, 2020.
- Society of Actuaries. "Substandard Annuities," Page 6. Accessed June 6, 2020.
- Insurance Information Institute. "Annuities Basics." Accessed June 6, 2020.
- Internal Revenue Service (IRS). "Topic No. 412 Lump-Sum Distributions." Accessed June 6, 2020.
- Internal Revenue Service (IRS). "Retirement Topics - Qualified Joint and Survivor Annuity." Accessed June 6, 2020.
- Internal Revenue Service (IRS). "Annuities - A Brief Description." Accessed June 6, 2020.
- Internal Revenue Service (IRS). "Publication 575: Pension and Annuity Income," Page 39. Accessed June 6, 2020.
Paul R. Piche began writing in 1976, penning publications on the impact of banking and manufacturing related to economic development. For more than 30 years Piche has written training and consumer materials for insurance companies. He has been active in the financial services industry since 1977 and has a Bachelor of Science in economics and two industry professional designations.