542 / How can one compute the tax-exempt portion of payments under a joint and survivor annuity where the size of the payments will increase or decrease after the first death?

(1)     Find the joint and survivor multiple in Table II or Table VI (depending on when the investment in the contract was made) under both annuitants’ ages and, if applicable, appropriate sexes. Multiply the amount of one year’s annuity payments to the survivor by this Table II or Table VI multiple.

(2)     Find the joint life multiple in Table IIA or Table VIA (depending on when the investment in the contract was made) under both annuitants’ ages and, if applicable, appropriate sexes. Determine the difference between the amount of one year’s annuity payments before the first death and the amount of one year’s annuity payments after the first death. Multiply this difference in amount by the multiple from Table IIA or VIA, whichever is applicable.

(3)     If payments are to be smaller after the first death, the expected return is the sum of (1) and (2). If payments are to be larger after the first death, the expected return is the difference between (1) and (2).

After computing the expected return, determine the exclusion ratio under the basic annuity rule: divide the investment in the contract ( Q 531) by the expected return under the contract (as computed above). This same exclusion ratio is applied to payments received before the first death and to payments received by the survivor. With respect to an annuity having a starting date after December 31, 1986, the exclusion ratio is applied to payments only until the investment in the contract is recovered.² However, in the case of an annuity with a starting date prior to January 1, 1987, the exclusion ratio continues to apply to all payments made, regardless of whether investment in the contract has been fully recovered or not.

Example 1. After July 30, 1986, Mr. and Mrs. Brown buy an immediate joint and survivor annuity that will provide monthly payments of $117 ($1,404 a year) for as long as both live, and monthly payments of $78 ($936 a year) to the survivor. As of the annuity starting date he is 65 years old; she is 63. The expected return is computed as follows.

Joint and survivor multiple from Table VI (ages 65,63)	26
Portion of expected return (26 × $936)		$24,336.00
Joint life multiple from Table VIA (ages 65, 63)	15.6
Difference between annual annuity payment before the first death
and annual annuity payment to the survivor ($1,404 – $936)	$468
Portion of expected return (15.6 × $468)		$7,300.80
Expected return		$31,636.80

Assuming that the Browns paid $22,000 for the contract, the exclusion ratio is 69.5 percent ($22,000 ÷ $31,636.80). During their joint lives the portion of each monthly payment to be excluded from gross income is $81.31 (69.5 percent of $117), or $975.72 a year. The portion to be included is $35.69 ($117 – $81.31), or $428.28 a year. After the first death, the portion of each monthly payment to be excluded from gross income will be $54.21 (69.5 percent of $78), or $650.52 a year. Of that monthly payment, $23.79 ($78 – $54.21), or $285.48 a year, will be included.

As noted above, if the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract. Thus, if Mr. Brown lives for 23 years, he may exclude $81.31 from each payment for 22 years ((12 × 22) × $81.31 = $21,465.84). In the next year, he may exclude $534.16 ($22,000 – $21,465.84) or $81.31 from each of the first six payments, but only $46.30 from the seventh. The balance is entirely includable in his income and on his death his widow must include the full amount of each payment in income.

Example 2. Assume that in the example above, there is a pre-July 1986 investment in the contract of $12,000 and a post-June 1986 investment in the contract of $10,000. Mr. Brown elects to calculate the exclusion percentage for each portion. The pre-July exclusion ratio would be 44.6 percent ($12,000 ÷ $26,910, the expected return on the contract determined by using Tables II and IIA and the age and sex of both annuitants). The post-June 1986 exclusion ratio is $10,000 ÷ $31,636.80 or 31.6 percent. The amount excludable from each monthly payment while both are alive would be $89.15 (44.6 percent of $117 plus 31.6 percent of $117) and the remaining $27.85 would be included in gross income. If the annuity starting date is after December 31, 1986, the total amount excludable is limited to the investment in the contract.