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.

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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? Once you’re comfortable with the basics, you can move on to topics like how to choose the right annuity based on your income, risk, and tax goals.

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. The same logic applies when comparing income riders; understanding the ratio pairs well with resources on how much an annuity income rider costs versus simply annuitizing the contract.

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 and coordinating with how much your heirs may need from other resources like life insurance coverage.

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, especially if you’re comparing them to designs like the inflation protected income annuity for rising-income potential.

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).

Funding sources matter too. Many clients explore moving employer plans into annuities—such as transferring a 457(b) to an annuity, transferring a deferred compensation plan, or moving a Keogh into an annuity. Each move comes with its own tax and RMD implications that should be reviewed alongside the exclusion ratio rules.

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.

Estimate Lifetime Income

Use our annuity income calculator to compare payouts

💡 Note: The calculator accepts premiums up to $2,000,000. If you’re investing more, results increase in direct proportion — for example, doubling your premium roughly doubles the guaranteed income at the same age and options.

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—then decide how that income will support goals like legacy planning, debt payoff, or final expenses.
• Coordinate with protection planning: Your annuity income often works alongside life, disability, and LTC coverage. If you’re still lining up the basics, it can help to review guides such as how much life insurance you need, how much long-term care insurance you need, and what long-term care insurance costs.
• Plan for end-of-life expenses: Some clients earmark a portion of annuity income for funeral or cremation costs so loved ones aren’t scrambling later. For estimates, see how much a funeral costs and how much it costs to be cremated.
• Check carrier quality: Long-term guarantees are only as strong as the insurer behind them. Many clients like to research major carriers individually using pages such as Is Guardian Life a good insurance company?, Is Farmers a good insurance company?, Is Country Financial a good insurance company?, and Is Ascensus a good company?
• Review niche coverage decisions: The same tax and income planning mindset you use with annuities can help with other products. For example, you might weigh whether critical illness insurance is expensive relative to your income plan, or compare coverage from carriers like Canvas Life and Colonial Penn as part of a broader risk review.

Helpful resources

• How Are Annuities Taxed?
• Does Annuitization Satisfy RMDs?
• Annuity Benefits
• How Much Long-Term Care Insurance Do I Need?
• Why families choose Diversified Insurance Brokers (video)

Want an after-tax income illustration?

We’ll compare SPIA, fixed indexed with income rider, and ladder options—showing the annuity exclusion ratio impact on each.

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