Many investors opt for non-qualified annuities to avoid paying taxes on their monthly payments. But even if you opt for a non-qualified annuity, a portion of your payment is still taxable. The annuity exclusion ratio is the percentage of your tax-free payments. 

Read on to learn how the IRS analyzes your annuity payments and which portions are taxable. We’ll also cover key concepts associated with the exclusion ratio.

What’s the exclusion ratio?

To understand an exclusion ratio, you need to know the difference between qualified and non-qualified annuities. 

Qualified vs. non-qualified annuity

A qualified annuity defers taxes until you start receiving payments — you use pre-tax income to buy the annuity, knowing that the full amount of your future payments is subject to income tax. 

• On the other hand, when you purchase an annuity with funds you’ve already paid taxes on, it’s non-qualified. For example, if you amassed $50,000 in savings from your salary, you could deposit those funds into a non-qualified annuity and the funds used to contribute towards the annuity are considered non-qualified. You’ll still have to pay taxes on your earnings, though. Once you begin to make withdrawals, each payment you receive will include a portion that is considered a return of your principal (non-taxable) and a portion that is considered interest or earnings (taxable).

The exclusion ratio

The exclusion ratio only applies to non-qualified annuities. It’s the percentage of your payment that is not subject to taxes. You calculate the annuity exclusion ratio like this:

Exclusion ratio = investment in contract / expected return

How the exclusion ratio applies to annuities

When you purchase a non-qualified annuity, you use after tax money. The exclusion ratio determines the tax you must pay on your payment. Some of your annuity payments come from your original contribution (the principal) and were already taxed, but the amount you earned, though, has not been. Those earnings are taxable, but not the amount returned as your original princpal — hence the "exclusion" part of the ratio. 

Exclusion percentage on a 1099

Your annuity provider is responsible for reporting your taxable income to the IRS. You’ll receive a Form 1099-R to break down taxable and non-taxable income based on the annuity exclusion ratio. You should verify the accuracy of your Form 1099-R with your accountant and bring any discrepancies to the insurance company’s attention. 

How to calculate the exclusion ratio

The calculation for the exclusion ratio formula involves dividing two figures:

• Investment in contract (cost basis): The amount of after-tax funds you used to buy the annuity. 
• Expected return: . This is the total amount you expect to receive from the annuity over its lifetime. For fixed annuities, this is typically calculated by multiplying the monthly payment by the number of months in your life expectancy.

Say you invest $100,000 of after tax money into an annuity contract that, once it reaches maturity, pays $500 per month for 20 years (or 240 months). That means:

• Investment in contract: $100,000
• Expected return: $120,000 ($500 x 240 months)
• Exclusion ratio: $100,000 / $120,000 = 83.3%

So, what’s the exclusion percentage on a 1099? According to the above example, it would be 83.3%, meaning that 83.3% of each $500 payment is tax-free, while the other 16.7% is taxable. The annual taxes on these payments would be 12 months x .167 x $500, or $1,002 of the $6,000 in payments.

Taxation of non-qualified annuity payments

Annuities aren’t a way to avoid taxes. With a qualified annuity, you defer your taxes until you receive payments. The IRS will consider 100% of your qualified annuity to be taxable income. And if you opt for a non-qualified annuity, you paid taxes on the principal before you entered the annuity, so the exclusion ratio applies. 

What happens when the exclusion ratio expires?

Once you’ve recovered 100% of the expected return, the IRS taxes all the payments that come after to be ordinary income. This event usually occurs if you live longer than the anticipated payout period. In the above example, the expected return occurs at the end of 20 years, but if the annuity pays beyond that period, the entire $500 monthly payment would be subject to income taxes. 

Explore qualified and non-qualified annuities with Gainbridge

The decision to invest in qualified or non-qualified annuities depends largely on your current income tax bracket and your anticipated income — luckily, Gainbridge offers both. Get in touch with an annuity professional today to figure out which account best fits your long-term financial vision.

FAQ

What’s the exclusion ratio in an annuity?

The annuity exclusion ratio applies to non-qualified annuities only and is the portion of an annuity payment that is taxable. The exclusion ratio formula is calculated as follows:

Exclusion ratio = investment in contract / expected return

Which portion of a non-qualified annuity payment is taxable?

To get the non-taxable portion of an annuity payment, multiply the entire payment amount by the exclusion ratio — usually represented as a percentage or decimal number. Then subtract that amount from the total payment. 

Taxable portion = total payment - (exclusion ratio x total payment)

• Annuity payment: $1,000 per month
• Exclusion ratio: 83.3%
• Non-taxable portion: $833
• Taxable portion: $167 ($1000 - (.823 x $1000))

Does an early withdrawal affect the exclusion ratio?

Yes. The IRS taxes annuity earnings before they tax the principal. Consider a non-qualified fixed annuity that you purchased for $100,000, but which has a current cash value of $120,000. If you withdraw funds early from a non-qualified annuity, the IRS typically applies a last-in, first-out (LIFO) rule, meaning the earnings are withdrawn and taxed before the principal. Let’s say If  withdraw $30,000 before maturity, the The IRS will apply the LIFO rule, and the $20,000 in earnings will be wtihdrawan first, and you will pay taxes on that portion, but  the remaining $10,000 is considered a return of principal. 
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Now, assume that at maturity, the annuity's cash value is $110,000, which consists of $90,000 in principal and $20,000 in gains. The exclusion ratio is 90,000 / 110,000 or 81.8%, which is different from what the ratio would be if you hadn’t withdrawn funds early. 

Remember, there may also be surrender charge, market value adjustment and if you are under age 59 ½ and IRS early withdrawal tax penalty

What’s the purpose of the exclusion ratio?

The exclusion ratio prevents double taxation. Because investors purchase non-qualified annuities with aftert-tax money,  IRS doesn’t require them to pay taxes on their initial investment when they receive their annuity payments.

Does the exclusion ratio apply to all annuities?

No, it only applies to non-qualified annuities. Investors buy qualified annuities with pre-tax money. When the annuity matures, 100% of the payments are taxable, so there isn’t a reason to apply the exclusion ratio.

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This article is for informational and educational purposes only and should not be relied on for investment, tax, or legal advice. You should speak to your own advisor for personal advice.