What it means
When you buy an annuity, part of every payment you later receive is simply your own capital coming back to you and part is investment growth. Tax authorities only want to tax the growth, so they need a rule for splitting each payment into those two pieces.
The exclusion ratio is that rule. The ratio is fixed at the outset from two figures: your investment in the contract, meaning the premiums you paid with money that had already been taxed, and your expected return, meaning the total payments you are projected to receive based on published life expectancy tables.
Divide the first by the second and you get a percentage that then applies to every payment you receive. Two retirees drawing the same monthly payment can owe very different amounts of tax, and the exclusion ratio is usually why.
Someone who funded an annuity out of savings that had already been taxed gets a large exclusion, while someone whose annuity was funded entirely with untaxed pension money gets none at all. The exclusion is not permanent.
Once you have recovered your entire investment in the contract, every later payment becomes fully taxable, which often catches long-lived annuitants by surprise in their eighties. If the annuitant dies before recovering the full investment, the unrecovered amount can usually be claimed as a deduction on the final tax return.
The same logic appears outside annuities, for example in structured settlements and some life insurance payouts, though the term used may differ. In every case the question is the same: what portion of the money coming back is your own capital, and how much of it is genuinely new income.
In practice
Real-world examples.
Example
A retired dentist buys a $250,000 annuity with money from the sale of her practice, on which she has already paid tax. Her exclusion ratio comes out at 62%, so almost two thirds of every payment arrives tax free. Her accountant uses this to keep her total declared income below the threshold where her state pension starts to be reduced.
Example
A financial adviser is comparing two products for a client: a taxable bond portfolio yielding $24,000 a year and an annuity paying $24,000 with a 45% exclusion ratio. Only $13,200 of the annuity income is taxable, so the after-tax comparison looks very different from the headline one. He presents both on an after-tax basis rather than a gross basis.
Example
A claimant receives a structured settlement paying $3,000 a month after a workplace injury. Her tax preparer confirms that the compensation element is excluded and only the interest component is reportable. Applying the exclusion correctly saves her several thousand dollars a year and avoids an amended return.
Formula
Calculation
Exclusion ratio = investment in the contract / expected total return. Excluded portion of each payment = payment x exclusion ratio.
A retiree pays $180,000 of after-tax savings into an immediate annuity. It pays $1,500 a month for life, and the relevant life expectancy table gives her 20 further years.
Expected total return = $1,500 x 12 months x 20 years = $360,000.
Exclusion ratio = $180,000 / $360,000 = 0.50, or 50%.
So $750 of each $1,500 payment is excluded as a return of capital and $750 is taxable. Over a full year she receives $18,000 in cash but declares only $9,000 as income. At a 22% marginal rate she pays $1,980 of tax rather than the $3,960 she would owe if the whole payment were taxable, a saving of $1,980 a year.
After 240 monthly payments, the excluded amounts total 240 x $750 = $180,000, which equals her original investment. From payment 241 onwards the full $1,500 is taxable, and her annual tax on the annuity rises to $3,960.Case study
Seen in the real world.
This is an illustrative and entirely fictional example. Northfield Retirement Advisers, an invented advice firm, reviewed the tax returns of a client who had been declaring her full annuity income for six years. She had paid $200,000 of after-tax money into a contract paying $2,000 a month, with an expected return of $2,000 x 12 x 25 = $600,000.
The correct exclusion ratio was $200,000 / $600,000 = 33.33%, so $666.67 of each payment should have been excluded, or $8,000 of the $24,000 received each year. Declaring the full $24,000 instead of $16,000 had cost her $8,000 x 24% = $1,920 of unnecessary tax annually, and roughly $11,520 over the six years.
The fictional firm filed amended returns for the open years and set a reminder for the year in which her $200,000 would be fully recovered, so that the exclusion would be switched off on time. The illustrative point is that an exclusion ratio is a one-off calculation with a long tail: get it wrong at the start and the error repeats every single month.
Watch out
Common mistakes.
- Assuming the whole annuity payment is tax free because you paid for the annuity with your own savings. Only the capital portion is excluded, and the growth element is ordinary taxable income.
- Continuing to apply the exclusion after the full investment has been recovered. Payments become fully taxable once the excluded amounts add up to what you originally put in.
- Applying an exclusion ratio to an annuity bought inside a pension using untaxed contributions. There is no after-tax investment in the contract, so the exclusion ratio is zero and everything is taxable.
Questions
People also ask.
How is the expected return calculated?
It is the payment amount multiplied by the number of payments expected under standard life expectancy tables, not by how long you personally think you will live.
Does the exclusion ratio change if I live longer than expected?
The percentage does not change, but the exclusion stops once your total investment has been returned, after which payments are fully taxable.
What happens to the unused exclusion if the annuitant dies early?
The unrecovered investment can generally be claimed as a deduction on the final tax return, so the benefit is not simply lost.
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