The exclusion ratio: how annuitized payments split into basis and gain

When a non-qualified annuity turns into a stream of payments, each payment is not wholly taxable and not wholly tax-free. Part of it is a return of the money you put in, which was already taxed, and part is gain. The exclusion ratio is the fraction that sets the split. This walk-through follows one hypothetical buyer from purchase to the day the tax-free part runs out, then looks at what happens if the buyer dies early or leaves a surviving spouse.

All numbers here are invented to make the arithmetic clear, including the life expectancy multiple. The real multiple comes from IRS tables or the insurer's own calculation, and a tax professional can confirm how your contract is treated. The glossary entry for the exclusion ratio gives the short definition, and the guide on how annuities are taxed puts it in the larger picture.

When the exclusion ratio applies

The ratio is used for payments from a non-qualified annuity after annuitization: that is, when the contract has been converted to a stream of payments for life or for a period of years. A Single premium immediate annuities (SPIAs): how they work is the clearest case, since it starts paying within about a year of purchase. A deferred contract that is annuitized later also qualifies, with a different starting point for the numbers.

It does not apply to:

• Withdrawals from a deferred contract that has not been annuitized. Those are taxed gains-first, as described in taxing a non-qualified annuity withdrawal: gains come out first.
• Annuities inside an IRA or employer plan. Their payments are generally taxed under other rules, usually fully taxable if the contributions were pre-tax.

The contract must have been bought with already-taxed money for there to be any basis to exclude. If there is no basis, every payment is taxable.

The formula in three numbers

The exclusion ratio is a simple fraction:

Exclusion ratio = investment in the contract ÷ expected return

• Investment in the contract is your cost basis: the after-tax premiums you paid, adjusted for certain things such as a refund feature (see below).
• Expected return is the total you are expected to receive over the payment period. For a lifetime annuity, it is the annual payment multiplied by a life expectancy multiple from the IRS tables, based on the annuitant's age at the annuity starting date. The insurer usually does this calculation.
• The result is a percentage that applies to each payment. The tax-free part is the payment times the ratio, and the rest is taxable ordinary income.

The ratio is fixed when payments start. It does not change from year to year, even if the annuitant's health changes or the insurer's tables are updated.

A worked example

Say a hypothetical buyer, Marcus, is 65 and pays $120,000 of after-tax money for a life-only immediate annuity that pays $750 a month, or $9,000 a year. Assume the insurer's expected return uses a multiple of 20.0 for his age (an illustrative figure, not the IRS table value to rely on).

• Expected return: $9,000 × 20.0 = $180,000
• Investment in the contract: $120,000
• Exclusion ratio: $120,000 ÷ $180,000 = 66.67%, or two-thirds

Each $750 payment splits like this:

• Tax-free: $750 × 2/3 = $500
• Taxable: $750 − $500 = $250

Over a year: $6,000 tax-free and $3,000 taxable. The taxable $3,000 is ordinary income, reported on the tax return for that year.

Now for how long. The tax-free portion continues until Marcus has received all of his $120,000 back tax-free. At $6,000 a year, that takes $120,000 ÷ $6,000 = 20 years. The table shows the progression:

The shape of the table is the lesson. For the first 20 years, a third of each check is taxable. In year 21, when Marcus is 85 in this example, the ratio stops, and the whole $9,000 becomes taxable. A person who lives to 90 collects 25 years of payments, or $225,000, of which $105,000 is taxable ($3,000 × 20 + $9,000 × 5) and $120,000 is the return of basis. That equals the total received minus the basis, as it should.

Two reasons the split is worth understanding in advance. First, a person who budgets for the early years from the after-tax amount may be surprised by a jump in taxable income in year 21, which can affect other income-based items. Second, the amount of the tax-free portion depends on an actuarial assumption, so a lower payment or a different payout option changes the ratio.

If the annuitant dies before the basis is recovered

A life-only annuity pays nothing after death. If Marcus died after 13 years, he would have received 13 × $6,000 = $78,000 of his basis back tax-free, and $42,000 would remain unrecovered. For annuities that started after 1986, the unrecovered amount is generally allowed as a deduction on his final income tax return. Whether that benefits the estate depends on the return and on how deductions are treated that year, so it is a question for the executor's tax preparer.

The same unrecovered basis question comes up if payments continue to someone else. That is why the next section matters.

When a survivor keeps receiving payments

Suppose Marcus instead chooses a joint-and-survivor annuity so that his spouse continues to receive payments after his death. Two things change. The monthly payment is lower, because payments are expected to last longer. And the expected return is higher, because it is based on two lives.

Say the hypothetical numbers are:

• Payment: $700 a month, or $8,400 a year
• Combined life expectancy multiple: 25.0 (illustrative)
• Expected return: $8,400 × 25.0 = $210,000
• Exclusion ratio: $120,000 ÷ $210,000 = 57.14%, or four-sevenths

Each $700 payment splits into $400 tax-free and $300 taxable. Over a year, $4,800 and $3,600. Taking payments from both lives together, the basis would be fully recovered after $120,000 ÷ $4,800 = 25 years.

If Marcus dies in year 12, his spouse generally continues with the same ratio. The tax-free part of each payment depends on the payment amount: at the full $700, it is still $400, and if the contract reduces the survivor's payment to $350, then $350 × 4/7 = $200 is tax-free and $150 is taxable. The exclusion keeps running until the total tax-free amount, across both lives, reaches the original $120,000. After that, every payment is fully taxable.

The ratio belongs to the contract, not to a person, so it follows the payments. The guide on what happens to an annuity when you die explains the payout options in more detail, and the post single life or joint-and-survivor: choosing how an income annuity pays compares the choices from the buyer's side.

Period certain and refund features

A period certain or refund option guarantees that payments continue to a beneficiary if the annuitant dies early. Because it increases what the insurer may pay out, the tax rules adjust the investment in the contract before the ratio is computed. In effect, part of your premium is treated as buying the guarantee, so the amount that qualifies for the ratio is reduced.

You do not usually need to calculate this yourself. The insurer figures the adjusted number and reports the tax-free amount. The point is that two annuities bought for the same premium and the same monthly check can have different exclusion ratios, because their guarantees differ. If you compare quotes, compare the tax-free percentage along with the payment. The annuity payout calculator estimates payments but not tax, so use it with the insurer's own figures.

Variable income annuities use a related idea. Because the payment amount changes, the tax-free portion is commonly figured as the investment in the contract divided by the number of expected payments, giving a fixed dollar amount per payment. Your insurer or a tax professional can show which method applies to a particular contract.

When a deferred contract is annuitized later

Say a deferred annuity bought for $100,000 is worth $160,000 when its owner converts it to payments. The basis is still $100,000, and the gain of $60,000 has not been taxed. After annuitization, the exclusion ratio spreads the basis across the payments, so each payment contains tax-free basis and taxable gain. The expected return is calculated on the payments the contract will make, so the ratio is $100,000 divided by that total.

Two details deserve a note. If only part of a contract is annuitized, the basis is generally allocated between the annuitized part and the rest, and the rule requires the payments to last for life or for at least ten years. And a 1035 exchange does not change the basis: the new contract takes over the old one's basis, so keep the records. The guide on how annuities are taxed covers the exchange rules.

What you will see on the tax form, and what to ask

The insurer reports annuity payments on Form 1099-R, showing the gross amount received and the taxable amount, and the difference is the tax-free part. The form is only as accurate as the basis the insurer has on file. Compare the taxable amount with your own calculation, using your records of the premium paid.

Questions to put to the insurer or a tax professional:

1. What is the investment in the contract and the expected return used to compute my ratio?
2. What is the exclusion percentage, and in dollars, how much of each payment is tax-free?
3. In which year will my basis be fully recovered, if I live as long as the tables assume?
4. How is a refund or period-certain feature reflected in the ratio?
5. If I die before the basis is recovered, or if a survivor continues, how will the unrecovered amount be handled?
6. Is any part of the contract treated differently, such as money from an exchange or a pre-1987 start date?

If the annuity started before 1987, older rules apply to the recovery of basis, which means the tax-free part may continue beyond the point where basis would be exhausted under today's rules. That is rare and specific, so a tax professional should confirm.

Annuitized lifetime payments can also qualify for an exception to the 10% additional tax that otherwise applies to earlier payouts. The post on taking annuity money before 59½: when the 10 percent tax applies covers it.

Checking the insurer's arithmetic

You do not have to take the insurer's figures on faith. With Marcus's numbers, the check takes five lines:

1. Annual payment: $750 × 12 = $9,000.
2. Expected return: the annual payment times the multiple the insurer used, $9,000 × 20.0 = $180,000.
3. Ratio: investment $120,000 ÷ expected return $180,000 = 66.67%.
4. Tax-free per year: $9,000 × 66.67% = $6,000.
5. Taxable per year: $9,000 − $6,000 = $3,000, which should match the taxable amount on the 1099-R.

If the form shows a different taxable amount, one of three things has usually happened. The insurer may have a different premium on file, perhaps because of an earlier exchange. It may have used a different multiple. Or the first year may be partial, since payments that begin mid-year produce a smaller first-year figure. Ask for the ratio, the investment in the contract and the expected return in writing, and compare them to your records.

One more rule of thumb: the first-year total is not the thing to check. The ratio is the thing, because it applies to every payment in every year.

Putting the ratio into a budget

Most people think of an annuity payment as a single number: $750 a month. After taxes, the number is different, and it changes at a known point. Using the example, here is a way to see it without any tax rates, just the shape:

• Years one to twenty: a third of each payment, $3,000 of $9,000 a year, adds to taxable income. The rest does not.
• Year twenty-one onward: the whole $9,000 a year adds to taxable income.

If Marcus's other income is stable, his taxable income from the annuity triples in year 21, and his tax on the annuity rises with it. The jump can also interact with other items that depend on income. A retiree who relies on the payments might ask a tax professional to project the years after the ratio runs out. Nothing about the payment itself changes; only the tax treatment does.

This is also why the exclusion ratio is not a rate of return. A high tax-free share does not mean the annuity is a good value, and a low one does not mean it is a poor value. The tax-free share is mostly a consequence of how much of the expected return is your own money. An older buyer with a shorter expected payout period has a higher ratio, because the same premium is spread across fewer expected payments, but the older buyer's payments are also larger for the same premium. What matters is the total after-tax income over the buyer's actual lifetime, compared with what other choices would deliver.

Common confusions

A handful of misunderstandings come up repeatedly.

• "The tax-free part is a refund of my premium, so after I get my premium back the payments stop." The payments continue for life; only the tax-free treatment ends.
• "The ratio is recalculated every year." It is set at the start and fixed, until the basis is recovered.
• "My payments are taxed as capital gains." They are ordinary income to the extent they are taxable.
• "A qualified annuity uses the same ratio." Inside an IRA or employer plan, payments follow different rules. There is often no basis, and the payments are taxable in full.
• "The insurer decides how much of my payment is taxable." The insurer applies the tax rules and reports the result. The calculation follows the tax code and IRS tables, and the insurer is expected to apply them correctly. If you think the basis on file is wrong, supply your records.

Key takeaways

• The exclusion ratio divides your after-tax investment by the expected total return, and applies the resulting percentage to each annuitized payment as a tax-free return of basis.
• The ratio is set when payments start and stays the same until the full basis has been recovered, after which every payment is fully taxable.
• If the annuitant dies before recovering the basis, the unrecovered amount is generally deductible on the final return for annuities that started after 1986.
• A survivor on a joint-and-survivor annuity generally continues with the same ratio, so the tax-free part follows the contract, not the person.
• Refund and period-certain features change the ratio, so compare the tax-free percentage along with the payment, and ask the insurer for its figures.