541 / How can one calculate the excludable portion of payments under a level payment joint and survivor annuity with refund or period-certain guarantee?

Investment in the Contract before July 1986

If Table II is used to determine the expected return for pre-July 1986 investment, the following method is used to determine the adjustment to the investment in the contract.¹ If Table VI is used to determine expected return for a pre-July 1986 investment, investment in the contract is adjusted using the formula for post-July 1986 investment (see subhead below).²

(1)     Determine the duration of the guaranteed amount (the number of years necessary for the guaranteed amount to be fully paid). In the case of a period-certain and life annuity, this is the number of years in the guaranteed period (e.g., 10, 15, or 20 “years certain”). To find the duration of the guaranteed amount, in years, for a cash or installment refund annuity, divide the total amount guaranteed under the contract by the amount of one year’s annuity payments. Round the quotient to the nearest whole number of years.

(2)     If the annuitants are not of the same sex, substitute for a female a male five years younger (or for a male, a female five years older). Then find the refund percentage factors in Table III under the whole number of years, as determined in (1), and the age of each annuitant of the same sex. Add these two Table III factors.

(3)     Using ages of the same sex, as adjusted in (2), add to the age of the older annuitant the number of years indicated in the table below opposite the number of years by which the ages differ.

Number of years difference in age (two male annuitants or two female annuitants)	Addition to older age in years
0 to 1, inclusive	9
2 to 3, inclusive	8
4 to 5, inclusive	7
6 to 8, inclusive	6
9 to 11, inclusive	5
12 to 15, inclusive	4
16 to 20, inclusive	3
21 to 27, inclusive	2
28 to 42, inclusive	1
Over 42	0

(4)     Find the refund percentage factor in Table III under the whole number of years as determined in (1) and the age of the older annuitant as adjusted in (3).

(5)     Subtract the Table III factor found in (4) from the sum of the Table III factors found in (2). The balance, if any, is the percentage value of the refund or period-certain guarantee. If there is no balance, no adjustment in the investment in the contract need be made for the value of the refund or period-certain guarantee. If there is a balance, continue with the following steps.

(6)     Apply the percentage value of the refund or period-certain guarantee as determined in (5) to the smaller of the investment in the contract ( Q 531) or the total guaranteed return under the contract. The result is the dollar value of the refund or period-certain guarantee.

(7)     Subtract the dollar value of the refund or period-certain guarantee from the investment in the contract. The remainder is the adjusted investment in the contract to be used in determining the exclusion ratio.

Example. Mr. and Mrs. Green purchase an immediate joint and survivor annuity that will pay $200 a month for 10 years certain and as long thereafter as either is alive. Mr. Green is 70 years old as of his birthday nearest the annuity starting date. Mrs. Green is 65. The single premium is $35,000. The total guaranteed amount is $24,000.

Investment in the contract (unadjusted)			$35,000
Percentage factor from Table III for male, age 70, and 10-year guarantee		21%
Percentage factor from Table III for male, age 60, and 10-year guarantee		11%
Sum of percentage refund factors		32%
Difference in years of age between two males, age 70 and 60	10
Addition in years to older age (Table above)	5
Percentage refund factor from Table III for male, age 75 and 10 year guarantee		29%
Difference between percentages		3%
Dollar value of period-certain guarantee (3% of $24,000)			720
Adjusted investment in the contract			$34,280
Table II multiple for male, age 70, and female, age 65			20.7
Expected return (20.7 × $2,400)			$49,680
Exclusion ratio ($34,280 ÷ $49,680)			69%
Excludable from gross income each year (69% of $2,400)*			$1,656
Includable in gross income each year ($2,400 – $1,656)*			$744

* If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract. After that has been recovered, the remaining amounts received are includable in income.³ However, if the annuity has a refund or guarantee feature, the value of the refund or guarantee feature is not subtracted when calculating the unrecovered investment.⁴

Investment in the Contract after June 1986

Where the investment in a contract has been made after June 30, 1986, IRS regulations provide a complex formula for determining the percentage factor that was developed for a pre-July 1986 investment using the first five steps above. This percentage factor is then applied as explained in Steps 6 and 7 above.⁵ The IRS will determine the amount of the adjustment on request.⁶