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.