What Is the Exclusion Ratio?
When you begin receiving income from an annuitized annuity, the IRS does not tax the entire payment. Part of what you receive is simply your own money coming back to you — money you already paid taxes on or that was contributed after-tax. That portion is excluded from taxable income. The exclusion ratio is the calculation that determines how much of each payment qualifies for this exclusion.
How the Exclusion Ratio Is Calculated
The formula: Investment in the Contract divided by Expected Return equals the Exclusion Ratio.
- Investment in the contract is your total after-tax premiums paid.
- Expected return is the total amount you are projected to receive based on your life expectancy and payment amount.
If you paid in $100,000 and your expected return over your lifetime is $200,000, the exclusion ratio is 50%. Half of each payment is tax-free return of principal; half is taxable earnings.
What Happens When You Outlive the Expected Return?
If you live past the point at which the full investment in the contract has been returned, the exclusion ends. From that point forward, the entire payment is taxable as ordinary income.
Non-Qualified vs. Qualified Annuities
The exclusion ratio applies to non-qualified annuities — those funded with after-tax dollars. In a qualified annuity (funded with pre-tax money such as an IRA rollover), the entire payment is generally taxable because no after-tax contributions were made. There is nothing to exclude.