537 / How is the excludable portion of payments computed under a single life annuity?

(1)     Determine the investment in the contract ( Q 531).

(2)     Find the life expectancy multiple in Table I or V, whichever is applicable for a person of the annuitant’s age (and sex, if applicable). Multiply the sum of one year’s guaranteed annuity payments by the applicable Table I or Table V multiple. For non-variable contracts, this is the expected return under the contract. For variable contracts, the “expected return” is the investment in the contract divided by the number of years over which payments will persist ( Q 550).

(3)     Divide the investment in the contract by the expected return under the contract, carrying the quotient to three decimal places. This is the exclusion ratio expressed as a percentage (“exclusion percentage”).

(4)     Apply the exclusion percentage to the annuity payment. The result is the portion of the payment that is excludable from gross income. The balance of the payment must be included in gross income. If the annuity starting date is after December 31, 1986, the exclusion percentage applies to payments received only until the investment in the contract is recovered. However, if the annuity starting date was before January 1, 1987, the same exclusion percentage applies to all payments received throughout the annuitant’s lifetime.¹

Example 1: On October 1, 2025, Mr. Brown purchased an immediate non-refund annuity that will pay him $125 a month ($1,500 a year) for life, beginning November 1, 2025. He paid $16,000 for the contract. Mr. Brown’s age on his birthday nearest the annuity starting date (October 1) was 68. According to Table V (which he uses because his investment in the contract is post-June 1986), his life expectancy is 17.6 years. Consequently, the expected return under the contract is $26,400 (12 × $125 × 17.6). The exclusion percentage for the annuity payments is 60.6 percent ($16,000 ÷ $26,400). Because Mr. Brown received two monthly payments in 2025 (a total of $250), he will exclude $151.50 (60.6 percent of $250) from his gross income for 2025, and he must include $98.50 ($250 – $151.50). Mr. Brown will exclude the amounts so determined for 17.6 years. In 2025, he could exclude $151.50; each year thereafter through 2041, he could exclude $909, for a total exclusion of $15,604.50 ($151.50 excluded in 2025 and $15,453 excluded over the next 17 years). In 2042, he could exclude only $395.50 ($16,000 – $15,604.50), which is all the investment in the contract he has left. In 2042, he would include in his income $1,104.50 ($1,500 – $395.50). In 2043 and each year thereafter, all cost basis has been recovered, and he would include $1,500 in income each year.

Example 2: If Mr. Brown purchased the contract illustrated above on October 1, 1986 (so that it had an annuity starting date before January 1, 1987), he would exclude $151.50 (60.6 percent of $250) from his 1986 gross income and would include $98.50 ($250 – $151.50). For each succeeding tax year in which he receives 12 monthly payments (even if he outlives his life expectancy of 17.6 years), he will exclude $909 (60.6 percent of $1,500), and he will include $591 ($1,500 – $909), even after 17.6 years’ worth of payments have been made.