Annuity Exclusion Ratio
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Annuity Exclusion Ratio (How Your Payments Are Taxed)
See what portion of each payment is a tax-free return of premium vs. taxable income—then coordinate your cash-flow and tax plan.
Annuity exclusion ratio is the IRS method for splitting each payment from a non-qualified annuity into two parts: a tax-free return of your original premium (basis) and a taxable earnings portion. Understanding the annuity exclusion ratio helps you line up after-tax income with RMD rules on annuitized IRAs, compare options like fixed annuities and fixed indexed annuities, and decide whether features such as an income rider fit your plan.
Annuity Exclusion Ratio: What It Is
When you buy a non-qualified annuity (after-tax money) and later turn it into income, the insurer applies an expected-payout calculation. The result—your exclusion ratio—determines how much of each check is tax-free until you’ve fully recovered your basis. After basis is recovered, any additional payments are generally taxable as ordinary income.
If you’re just getting oriented, these primers can help: What Is a Fixed Annuity?, What Is a Fixed Indexed Annuity?, and What Is a RILA?
How to Calculate the Exclusion Ratio
Mechanics of the annuity exclusion ratio
- Investment in the contract (basis): Your total after-tax premiums, minus any previous non-taxable withdrawals.
- Expected return: The insurer’s total anticipated payouts for your chosen option (life only, joint life, or period-certain), based on actuarial assumptions.
- Exclusion Ratio: Basis ÷ Expected Return ⇒ the percentage of each payment that’s tax-free.
- Per-payment split: Payment × ratio = tax-free portion; the remainder is taxable income.
Important: the ratio is tied to your payout election. Change the option and the expected return changes—so the tax-free percentage can change, too.
Payout Options & the Exclusion Ratio
Life only, refund, joint, and period-certain
Life Only: Highest payment; expected return is based on your life expectancy. The annuity exclusion ratio spreads basis over that expectation. If you outlive the expectation, payments after basis recovery are fully taxable.
Life with Refund / Installment Refund: Slightly lower payments. If you pass away before your basis is recovered, the unpaid basis is returned to beneficiaries (generally income-tax-free), which can be attractive for legacy planning.
Joint & Survivor: Covers two lives. Expected return usually increases, so the exclusion ratio (tax-free % of each payment) can be different than life-only.
Period-Certain (e.g., 10-year): Fixed number of payments; the expected return equals the total guaranteed payout over the period, making the math straightforward.
Prefer to keep assets growing while waiting to turn on income? Review FIA income riders and laddering annuities for timing strategies.
Qualified vs. Non-Qualified Taxation
Where the annuity exclusion ratio applies
- Non-Qualified (after-tax): The annuity exclusion ratio applies until your basis is fully recovered; thereafter, payments are taxable.
- Qualified (IRA/401k): Payments are typically fully taxable because contributions were pre-tax. If you annuitize inside an IRA, scheduled payments generally satisfy the RMD for that specific contract (other IRA balances still have their own RMDs).
Not sure how your overall annuity mix will be taxed? Start with How Are Annuities Taxed? for a wider overview.
Advanced Considerations for the Exclusion Ratio
1035 exchanges, partial annuitization, and basis at death
- 1035 Exchange: Moving one non-qualified annuity into another via a tax-free 1035 exchange carries your basis to the new contract. If you later annuitize, the new exclusion ratio uses the carried basis.
- Partial Annuitization: You can sometimes annuitize a portion of a contract (creating income on that slice) while leaving the rest deferred. Only the annuitized slice uses the exclusion ratio.
- Death Before Basis Recovery: With life-only, remaining unrecovered basis may be deductible on the final return (subject to IRS rules). With refund options, unrecovered basis is typically returned to beneficiaries tax-free.
- Inflation Adjustments: If you choose a cost-of-living adjustment on payments, the expected return changes, which can alter the annuity exclusion ratio and your annual tax-free amount.
Exclusion Ratio Examples
Example 1: Non-Qualified SPIA (Life Only)
Premium $120,000; expected lifetime payouts $200,000 ⇒ exclusion ratio = 0.60. A $1,000 monthly payment is $600 tax-free / $400 taxable until $120,000 of basis is recovered. If you live beyond that point, later payments are fully taxable.
Example 2: Joint Life with Installment Refund
Premium $200,000; expected payouts $320,000 ⇒ ratio = 0.625. A $1,500 monthly payment would be ~$937.50 tax-free / ~$562.50 taxable. If both spouses pass before $200,000 of basis is returned, beneficiaries receive the remainder tax-free.
Example 3: Period-Certain (10-Year)
$100,000 premium; total guaranteed payouts $132,000 ⇒ ratio ≈ 0.7576. If annual payout is $13,200, then ~$10,000 is tax-free and ~$3,200 taxable each year for 10 years.
Planning Tips with Real-World Links
Put the annuity exclusion ratio to work
- Compare after-tax income sources: Use our “How much does X annuity pay?” series for cash-flow context: $1M, $3M, and $10M scenarios.
- Sequence decisions: Decide whether to annuitize, add an income rider, or ladder contracts based on rates and liquidity needs.
- Rate shopping matters: Payouts and internal assumptions vary by carrier. Start with current fixed annuity rates, then request a customized illustration.
- Coordinate with Social Security & Medicare: The timing of income can affect IRMAA and taxation. Learn how programs interact here: Medicare & Social Security.
Helpful resources
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We’ll compare SPIA, fixed indexed with income rider, and ladder options—showing the annuity exclusion ratio impact on each.
