The exclusion ratio of an individual whose annuity starting date is after December 31, 1986 applies to payments received until the payment in which the investment in the contract is fully recovered. In that payment, the amount excludable is limited to the balance of the unrecovered investment. Payments received thereafter are fully includable in income, as all cost basis has been recovered at that point. The exclusion ratio as originally determined for an annuity starting date before January 1, 1987 applies to all payments received throughout the entire payment period, even if the annuitant has recovered his or her investment. Thus, it is possible for a long-lived annuitant with a pre-January 1, 1987, annuity to receive tax-free amounts which in the aggregate exceed his or her investment in the contract.
The exclusion ratio for a particular contract is the ratio that the total investment in the contract bears to the total expected return (payments) under the contract. By dividing the investment in the contract by the expected return, the exclusion ratio can be expressed as a percentage (which the regulations indicate should be rounded to the nearest tenth of a percent).
For example, assuming that the investment in the contract is $12,650 and expected return is $16,000 (e.g., $800/year for 20 years), the exclusion ratio is $12,650/$16,000, or 79.1 percent (79.06 rounded to the nearest tenth of a percent). If the monthly payment is $100, the portion to be excluded from gross income is $79.10 (79.1 percent of $100), and the balance of the payment is included in the gross income. If twelve such monthly payments are received during the taxable year, the total amount to be excluded for the year is $949.20 (12 × $79.10), and the amount to be included is $250.80 ($1,200 – $949.20). Excess interest, if any, also must be included.
If the investment in the contract equals or exceeds the expected return, the full amount of each payment is received tax-free.
Taxation of Annuity Payments to Beneficiary
If an annuitant under a life annuity payout with a refund feature dies and there is value remaining in the refund feature, the taxation of payments to the beneficiary under the refund feature depends on whether that beneficiary elects a new payout arrangement.
If proceeds under the refund feature are taken by the beneficiary either as a lump sum or in accordance with the annuity payout option under which the annuitant’s payments were calculated, proceeds will be excludable from income until the total amount the beneficiary receives, when added to the amounts received tax-free by the annuitant, is equal to the annuitant’s “investment in the contract,” unadjusted for the value of the refund feature. This “FIFO” (first-in, first-out) basis-first treatment of beneficiary payments is different than the income/gains-first treatment applying to “amounts not received as an annuity” and from the “regular annuity rules” treatment that normally applies to annuitized payments.
If the total payments thus made to the beneficiary are less than the annuitant’s investment in the contract and the annuitant’s annuity starting date was after July 1, 1986, the beneficiary may take an income tax deduction for any such unrecovered investment.
Previously, the owner of an annuity or life insurance contract who wanted to annuitize a portion of a contract was required to split a contract into two and annuitize one of the resulting contracts. Splitting the contract was treated as a partial withdrawal and the owner was taxed prior to annuitization. As of 2011, that cumbersome two-step process is no longer necessary.
That’s because President Obama signed the Small Business Jobs and Credit Act of 2010, (H.R. 5297). Section 2113 of the law amended IRC §72(a) to permit partial annuitization of annuity, endowment, and life insurance contracts – leaving the balance unannuitized – as long as the annuitization period is for ten years or more or is for the lives of one or more individuals.
When a contract is partially annuitized: (1) each annuitized portion of the contract is treated as a separate contract; (2) for purposes of calculating the taxable portion of annuity payments from a partially annuitized contract, investment in the contract is allocated pro rata between each portion of the contract from which amounts are received as an annuity and the portion of the contract from which amounts are not received as an annuity; and (3) each separately annuitized portion of the contract will have a separate annuity start date.
Partial annuitization is permissible for tax years beginning after December 31, 2010.