An exclusion ratio is the percentage of the amount you receive from an annuity that is excluded from your gross income. In certain tax-advantaged retirement vehicles, like annuities, the gains are only taxed when you receive them. However, the portion of your payout that the IRS taxes depends on how you fund your annuity—either as a qualified or non-qualified income annuity—and how you receive the funds from it. In most cases, the exclusion ratio applies to non-qualified annuities.
Learn more about the exclusion ratio, how it works, and what it means for your investment.
Definition and Example of an Exclusion Ratio
An exclusion ratio represents the percentage of an annuity payment that doesn’t count as gross income, hence that amount is not subject to taxation. This ratio is calculated by dividing the investment in the contract by the expected return. Any amount above the exclusion ratio is subject to taxation.
To apply an exclusion ratio, you need to be receiving payments from an annuity (not just making withdrawals). In other words, you need to annuitize the contract so that it pays regular, guaranteed payments for a specified period of time, such as for life. When you annuitize, you can no longer make withdrawals from or have access to the contract value.
- Alternate name: General Rule
Use these steps to calculate the exclusion ratio and determine the amount you can exclude from your income:
- Determine your initial investment: This is the amount you invested in the annuity, minus any offsets, such as a refund feature.
- Calculate your expected return: This is the amount you’ll receive annually adjusted by a multiplier based on your age, the type of payout, and the number of annuitants (if it’s a single or joint-life annuity). You can find multipliers in the actuarial tables in IRS Publication 939.
- Calculate the exclusion ratio: Divide step 1 by step 2 to get the exclusion ratio.
- Determine the tax-free portion of your annuity payment: Multiply this percentage by the annual payment you receive to determine the tax-free portion of your annual annuity payment.
Let’s assume that you buy a single premium immediate annuity for $10,000, and it promises to pay $100 per month ($1,200 per year) for the rest of your life. If the initial investment is $10,000, you need to next determine your expected return. To do this, you multiply your annual payment ($1,200) times the correct multiplier based on your age and the type of payment you receive.
Since your annuity payment is based on your life only and will be paid for as long as you live, you should look at Table V in IRS Publication 939. If you are 70 years old, the multiplier would be 16. Therefore, your expected return = 16 x $1,200 = $19,200.
The exclusion ratio is:
Investment / Expected Return = $10,000 / $19,200 = 0.52 or 52%
52% is the portion of your payment that is tax-free. It’s equal to $624 per year (52% of $1,200). The remaining $576 is treated as taxable income.
Where there are multiple annuities, the exclusion ratio is calculated by dividing the total investment by the aggregate expected returns.
How an Exclusion Ratio Works
Annuities grow tax-deferred and, generally, you’ll pay taxes only when you receive distributions either through regular annuity payments or via withdrawals. However, the IRS considers how you fund the annuity when determining how to tax you on it. In other words, did you already pay income tax on the money invested, or did you deduct it on your tax return?
Qualified annuities are purchased through qualified retirement plans like a 401(k) and are funded with pre-tax dollars. As a result, the full annuity payout is treated as taxable ordinary income. Non-qualified annuities are funded with after-tax money—the IRS will only tax the growth portion of your annuity.
If you don’t annuitize, but instead take withdrawals, the money withdrawn is treated on a last-in-first-out basis, or LIFO. What this means is that the last funds to go into the annuity (the gains) are withdrawn first. It’s only after you completely withdraw the growth portion, in this case, that you’ll receive tax-free benefits.
You pay regular income tax on annuity gains, not capital gains tax.
You’ll need to convert your annuity into a stream of regular payments to eliminate the need to exhaust the growth portion of your investment to receive tax-free funds. This is called annuitization. After annuitizing your annuity, the income stream is now taxed based on an exclusion ratio. The exclusion ratio determines the taxable and non-taxable portion of your annuity payments.
What It Means for Your Retirement Benefits
Section 72 of the Internal Revenue Code provides clear regulations on the income taxation of annuities. The regulations let you receive your initial investment tax-free over the payment period while taxing the balance of the amount received.
Early withdrawals prior to age 59½ from an annuity contract may have a penalty tax of 10% on the amount withdrawn in addition to regular income tax.
But what if you live beyond that life expectancy? The implication is that you’ll pay higher taxes. Surpassing your life expectancy means you’ll recoup your entire initial investment (principal). As a result, all payments beyond that point are fully taxable.
Remember, the exclusion ratio applies only to annuities you fund with after-tax dollars. You’ll pay taxes on 100% of annuity payments you receive through a tax-deferred account like an IRA or 401(k). You won’t, however, pay taxes on any portion of annuity payments received from a Roth account, such as a Roth 401(k) or Roth IRA (unless you make early withdrawals).
- The exclusion ratio helps determine the taxable portion of your annuity payments.
- The exclusion ratio is calculated by dividing the original investment in an annuity contract by the expected return.
- The exclusion ratio doesn’t apply to qualified tax-deferred retirement accounts, for which all annuity payments are fully taxable.
- Any payouts after your full life expectancy are taxed as ordinary income since you’ve already exhausted your principal.