Glossary

Exclusion ratio

The fraction of each annuity payment treated as a tax-free return of the buyer's own money, found by dividing cost basis by expected total payments.

The exclusion ratio is the IRS method for splitting payments from an annuitized non-qualified annuity into a tax-free part and a taxable part. Because the buyer paid for the contract with after-tax money, part of each payment is simply that money coming back, and only the rest is taxable earnings.

Formula: exclusion ratio = investment in the contract ÷ expected return. The expected return is the total the contract is expected to pay; for a lifetime annuity, it is based on the annuitant's life expectancy from IRS tables. Hypothetical example: a 70-year-old pays $200,000 for an immediate annuity paying $15,000 a year for life. If the IRS tables give an expected return of $240,000, the ratio is $200,000 ÷ $240,000, or 83.3%, so $12,500 of each year's payments is tax-free and $2,500 is taxable.

Once the annuitant has recovered the full investment, here after 16 years, later payments become fully taxable. If the annuitant dies before recovering it, the unrecovered amount can generally be deducted on the final income tax return. The ratio applies to non-qualified annuities; payments from an annuity in an IRA or 401(k) are usually fully taxable because no after-tax money went in. See how annuities are taxed and Single premium immediate annuities (SPIAs): how they work.

Last reviewed October 4, 2026

In the index now

Related terms

Cost basis For life insurance and annuities, the after-tax money put in (premiums minus tax-free amounts taken out), which sets how much of a payout is taxed. Annuitization Converting an annuity's account value into a stream of guaranteed payments for life or a set period, usually giving up access to the lump sum. Non-qualified annuity An annuity bought with after-tax money outside an IRA or employer plan; earnings grow tax-deferred, and only the gains are taxed when withdrawn. Immediate annuity An annuity bought with a lump sum that starts paying income within about a year, for life or a set period, in exchange for giving up access to the money. Life expectancy The average number of additional years people of a given age are expected to live, calculated from mortality tables for a population or group.

Related guides

Building an annuity ladder How laddering MYGAs or income annuities spreads interest-rate and longevity risk across staggered maturities, with a hypothetical example and the trade-offs. How annuities are taxed Annuity earnings grow tax-deferred and are taxed as ordinary income at payout; rules differ for qualified, non-qualified, early and inherited annuities. Life insurance vs annuities: opposite tools for opposite risks Life insurance protects your family if you die too soon; an annuity protects your income if you live too long. How they differ on risk, tax and who each suits. Single premium immediate annuities (SPIAs): how they work A SPIA turns a lump sum into income that starts within a year. How payout options, pricing, inflation and taxes work, and who a SPIA suits and doesn't.