Exclusion Ratio

The exclusion ratio is the fraction of each payment from an annuitized annuity contract that is excluded from taxable income, set under Internal Revenue Code Section 72(b) as the investment in the contract divided by the expected return under the contract, both measured as of the annuity starting date.

An annuity contract is turned into a stream of payments through annuitization, and the date that happens, the annuity starting date, is the single input that locks in the exclusion ratio for the life of the payment stream. "Investment in the contract" means the after-tax premiums paid in, minus certain amounts already recovered tax-free. "Expected return" is the total amount the contract is projected to pay out over the annuitant's actuarial life expectancy, or over the certain period for a period-certain annuity, using IRS actuarial tables.

Divide the first figure by the second and the result is a percentage that applies to every payment, for as long as payments continue, no matter how long the annuitant lives. If the ratio comes out to 30%, then 30% of every check is a tax-free return of the annuitant's own money and 70% is taxable ordinary income, whether that's the fifth payment or the two-hundredth.

The exclusion ratio has a stopping point built in: under Section 72(b)(2), it can never exclude more than the annuitant's remaining unrecovered investment. Someone who outlives their actuarial life expectancy will, at some point, fully recover their investment; from that payment forward, the entire payment becomes taxable, because there is no basis left to exclude. Someone who dies before recovering the full investment can instead deduct the unrecovered amount on their final income tax return under Section 72(b)(3), the law's way of making sure the after-tax money that went in is eventually accounted for one way or another.

A different mechanism applies to annuities paid from a qualified employer retirement plan: the Simplified Method under Section 72(d) divides the investment in the contract by a number of anticipated payments taken from an IRS table based on age, rather than by an actuarially computed expected return. It serves the same purpose, spreading tax-free recovery of basis across the payment stream, but the arithmetic differs.

None of this applies to an annuity purchased inside a traditional IRA or an employer plan with pre-tax dollars: because no after-tax money went in, there is no basis to recover, and every payment is fully taxable as ordinary income. The exclusion ratio is a nonqualified-annuity concept only.

A hypothetical example: Frank pays $120,000 for an immediate annuity that his insurer expects, using IRS life-expectancy tables, to pay out a total of $200,000 over his life. His exclusion ratio is $120,000 ÷ $200,000 = 60%. He receives $1,500 a month; 60% of that, $900, is a tax-free return of his own money, and the remaining $600 is taxable.

If Frank lives long enough to receive a total of $120,000 in tax-free amounts, roughly 133 monthly payments of $900 each, his investment is fully recovered, and every payment after that point is 100% taxable, the full $1,500 rather than $900 of it.

Pros

• Spreads recovery of your own after-tax money across the payment stream, instead of taxing the entire premium at once.
• The percentage is fixed for the life of the contract once calculated, so there's no year-to-year guessing about how much of a payment is taxable.

Cons

• The ratio is calculated using actuarial life-expectancy tables, not your actual lifespan, so someone who dies early or lives unusually long ends up with a different real-world outcome than the math assumed.
• Living past your actuarial life expectancy means eventually losing the tax-free portion entirely, right when the payments matter most.