7 Annuity Exclusion Ratio Basics to Know

Analysis July 27, 2023 at 01:08 PM Share & Print

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One way for a financial advisor to get attention is to find a compliance-compatible way to post a guide to annuity exclusion ratio basics.

The annuity exclusion ratio is an Internal Revenue Code provision that can reduce the federal income taxes on the cash coming out of a client’s annuity sharply.

It can also help a financial advisor who believes that an annuity is a good option for a client to respond to the criticism that annuities saddle their owners with big tax bills.

Examples of financial services firms that have posted discussions of the relationship between annuities and the U.S. federal income tax exclusion ratio are The Annuity Expert, Canvas, Finance Strategists and The Retirement Group.

Nationwide and CNO Financial’s Center for a Secure Retirement are examples of insurance companies and company-linked organizations that have posted annuity exclusion ratio guides.

Here are seven basic things to know about how the exclusion ratio applies to simple situations involving fixed annuities that your client purchased, rather than inherited. These items are based on an Internal Revenue Service publication, General Rule for Pensions and Annuities, and The National Underwriter Company’s The Advisor’s Guide to Annuities.

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1. Annuity exclusion ratio rules have wrinkles.

If you're not already a tax lawyer, a tax accountant or the holder of the Chartered Life Underwriter designation or the equivalent, with extensive experience with annuity tax considerations, the main reason to learn about the exclusion rules is to be able to have intelligent conversations with annuity tax specialists and to know why you're encouraging clients to talk about their annuities with their tax advisors.

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2. The exclusion amount rules that apply depend on the situation.

Some of the considerations that affect the calculations include when the annuity was purchased; whether the annuity is a fixed annuity or a variable annuity; whether the owner of the annuity bought the annuity or inherited it; whether the annuity is held inside an individual retirement account, a 401(k) plan account or another arrangement that qualifies for special tax treatment; and the life expectancy of the recipient of the annuity income.

3. The IRS thinks in terms of "amounts received as an annuity," not in terms of the kinds of annuity contracts you happen to sell.

You may use the word "annuity" to refer to a contract that can provide a stream of income and is backed by an insurance company.

The IRS annuity income rules apply to "amounts received as an annuity," or "a series of payments over time in which the principal (or purchase price) and interest are amortized over the payout period, so that no value remains at the end of the annuity period," according to The Advisor's Guide to Annuities.

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4. Internal Revenue Code section 72 sets the exclusion ratio rules for amounts received as annuities.

For payments to count as amounts received as annuities, the taxpayer must get amounts paid at regular intervals for a period longer than one year from the payment start date, according to the IRS General Rule for Pensions and Annuities Guide.

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5. The basic formula for a fixed annuity is simple.

The exclusion ratio equals the client's total investment in the annuity contract divided by the expected return.

Here's the 6-step guide to using the exclusion ratio with fixed annuities without any special refund features or death benefits used, with income payments to living annuity purchasers starting after 1986:

Step 1

Figure the amount of the investment in the contract.

Step 2

Figure the expected return, using another set of IRS instructions.

Step 3

Divide the results of Step 1 by the results of Step 2 and round to three decimal places. This formula gives the client the exclusion percentage.

Step 4

Multiply the exclusion percentage by the first regular periodic payment. The result is the tax-free part of each pension or annuity payment.

Step 5

Multiply the tax-free part of each payment (Step 4) by the number of payments received during the year. This formula shows the client the tax-free part of the total payment for the year.

Step 6

Subtract the tax-free part from the total payment the received. The rest is the taxable part of the annuity.

6. The exclusion ratio reduces the client's taxes for a limited amount of time.

In the IRS guide, officials give the example of someone who bought a fixed annuity for $10,8000. The annuity is supposed to pay the taxpayer $100 per month for life.

The taxpayer is 65, and an IRS table provides a life expectancy-related figure of 20.0 to feed into tax calculations.

The IRS says the expected return for the annuity is 20.0 times 12 times $100, or $24,000. The exclusion ratio is the cost of the contract divided by the expected return, or $10,800 divided by $24,000, which is equal to 45%.

"This is the percentage you won't have to include in income," the IRS says. "Each year, until your net cost is recovered, $540 (45% of $1,200) will be tax free and you will include $660 ($1,200 minus $540) in your income."

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7. The limit on the exclusion was more generous for people with annuities that started before 1987.

"If your annuity starting date was before 1987, you could continue to take your monthly exclusion for as long as you receive your annuity," according to the IRS. "The total exclusion may be more than your investment in the contract.

For a client with an annuity start date after 1987, the exclusion ends after the sum of the annuity payments paid equals the net cost of the annuity.

"Thereafter," the IRS warns, "your annuity payments are fully taxable."

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