Q: How is the excludable portion of an annuity payment under a fixed period or fixed amount option computed?
A: The rule varies depending on whether you have a variable or non-variable contract.
The basic annuity rule (Q 359) applies: Divide the investment in the contract (Q 360) by the expected return under the contract to determine the exclusion ratio for the payments. Apply this ratio to each payment to find the portion that is excludable from gross income. The balance of the payment is includable in gross income.
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If payments are for a fixed number of years (without regard to life expectancy), the expected return is the guaranteed amount receivable each year multiplied by the fixed number of years.
If payments are for a fixed amount (without regard to life expectancy), the expected return is the total guaranteed amount of payments. Additional payments made after/beyond the guaranteed amount (due to excess interest) are fully taxable.
To compute the excludable portion of each payment by a short method, divide the investment in the contract by the number of guaranteed payments. The result will never vary more than slightly from the exact computation.
Example 1. The owner of a maturing $25,000 endowment elects to receive the proceeds in equal annual payments of $2,785 for a fixed 10 year period. Assuming that the owner’s investment in the contract is $22,500, the owner may exclude $2,250 ($22,500 ÷ 10) from gross income each year. The owner must include the balance of amounts received during the year in gross income.
Example 2. The owner of a maturing $25,000 endowment elects to take the proceeds in monthly payments of $200. The company’s rate book shows that payments of $200 are guaranteed for 144 months. Assuming that the owner’s investment in the contract is $22,500, the owner can exclude $156.25 ($22,500 ÷ 144) of each payment from gross income, and must include $43.75 ($200 – $156.25). Thus, for a full 12 months of payments, the owner excludes $1,875 (12 × $156.25) and includes $525 ($2,400 – $1,875). Additional payments received after the 144 month period are fully taxable.
If the payee dies before the guaranteed period expires, the payee’s beneficiary will exclude the same portion of each payment as originally computed.
A penalty tax may be imposed on any payments received under the contract unless one of the exceptions listed in Q 356 is met.