What Is an Exclusion Ratio?
The portion of your annuity payment that is deducted from your gross income is known as an exclusion ratio. Gains in some tax-advantaged retirement products, such as annuities, are only taxed when you get them. However, how you fund your annuity—as a qualified or non-qualified income annuity—and how you receive the money from it determines the percentage of your payout that the IRS taxes. The exclusion ratio often applies to non-qualified annuities.
Study up on the exclusion ratio to understand how it functions and what it means for your investment.
Definition and Example of an Exclusion Ratio
An exclusion ratio is the portion of an annuity payment that is not considered gross income and is therefore not taxed. To determine this ratio, divide the investment in the contract by the expected return. Any amount above the exclusion ratio is subject to taxation.
You must be receiving annuity payments to use an exclusion ratio (not just making withdrawals). In other words, you must annuitize the contract for it to make consistent, assured payments for a given amount of time, such as for life. When you annuitize, the contract value is no longer yours to access or can no longer be withdrawn from.
- Alternate name: General Rule
Follow these methods to compute the exclusion ratio and estimate how much of your income can be excluded:
- Calculate your initial outlay: This represents your initial investment in the annuity less any offsets, like a refund feature.
- Make a return calculation: This is the annual compensation you’ll receive, multiplied by a factor determined by your age, the nature of the payout, and other factors number of annuitants (if it’s a single or joint-life annuity). You can find multipliers in the actuarial tables in IRS Publication 939.
- Do the exclusion ratio calculation: To find the exclusion ratio, divide step one by step two.
- Determine the amount of your annuity payment that is tax-free: To calculate the fraction of your annual annuity payment that is tax-free, multiply this percentage by the amount you get each year.
Assume you spend $10,000 on a single premium instant annuity that guarantees you’ll receive $100 a month ($1,200 a year) for the rest of your life. You must next determine your projected return if the initial investment is $10,000. You must multiply your annual payment ($1,200) by the appropriate multiplier based on your age and the type of payment you get to achieve this.
Because your annuity payment is solely based on your life and will be paid as long as you live, you should look at Table V in IRS Publication 939. If you are 70 years old, the multiplier would be 16. Therefore, your expected return = 16 x $1,200 = $19,200.
The exclusion ratio is:
Investment / Expected Return = $10,000 / $19,200 = 0.52 or 52%
52% is the portion of your payment that is tax-free. It’s equal to $624 per year (52% of $1,200). The remaining $576 is treated as taxable income.
How an Exclusion Ratio Works
In general, you won’t pay taxes on annuity growth until you receive distributions, such as regular annuity payments or withdrawals. Annuities grow tax-deferred. However, while considering how to tax you on the annuity, the IRS takes into account how you finance it. To put it another way, did you already pay income tax on the invested money or did you write it off on your tax return?
Pre-tax funds are used to acquire qualified annuities through qualified retirement plans, such as a 401(k). The entire annuity payout is consequently considered taxable regular income. Non-qualified annuities are paid for with after-tax funds; the IRS only taxes the annuity’s growing component.
If you want to take withdrawals rather than annuitize, the money is handled according to the last-in-first-out rule, or LIFO. What this means is that the last funds to go into the annuity (the gains) are withdrawn first. It’s only after you completely withdraw the growth portion, in this case, that you’ll receive tax-free benefits.
What It Means for Your Retirement Benefits
To avoid having to use up the investment’s growing share before receiving tax-free money, you’ll need to change your annuity into a stream of regular payments. The term for this is annuitization. Your income stream is now taxed based on an exclusion ratio after you have annuitized your annuity. The taxable and non-taxable portions of your annuity payments are determined by the exclusion ratio.
The Internal Revenue Code’s Section 72 lays out precise guidelines for the income taxation of annuities. The rules allow you to defer paying taxes on the remainder of the money you received while receiving your initial investment tax-free over the payment period.
However, what if you live longer than that? It is implied that your tax burden will increase. If you live longer than expected, you’ll get back all of your initial investment (principal). Therefore, all payments made after that are entirely taxed.
Keep in mind that the exclusion ratio only applies to annuities that are paid for with after-tax funds. If you get annuity payments through a tax-deferred account, such as an IRA or 401(k), you must pay taxes on all of them (k). However, any portion of annuity payments you receive through a Roth account, such as a Roth 401(k) or Roth IRA, won’t be subject to taxes (unless you make early withdrawals).