What Is Your Immediate Annuity Exclusion Ratio and How Can It Impact Your Retirement Tax Burden?

immediate annuity exclusion ratio

“What is an exclusion ratio?” Whenever one of my clients is considering buying an immediate annuity, that’s one of the first questions they have. It’s an important number, but getting to that number is a complex road. An exclusion ratio will determine what portion of each year’s income payment is non-taxable on an immediate annuity. A lot of my clients like to know the specifics of how it’s calculated so they can estimate their taxes. What they don’t know is it can also be a good way to help lower their overall tax burden.  

When ‘Non-Qualified’ Is A Good Thing

A non-qualified annuity is one that was purchased with after-tax dollars. So if you’re funding an immediate annuity with a 1035 exchange from another annuity or out of your retirement account, you’re not going to have an exclusion ratio because taxes were originally deferred on the full amount which means each income payment, in its entirety, is fully taxable.

But if you buy a non-qualified immediate annuity, out-of-pocket or outside of a retirement account, a portion of each income payment will be considered a return of principal and therefore, will be nontaxable. In other words, an exclusion ratio will be applied that can significantly lessen your tax burden on these funds. This is because you’ve already paid the tax on the principal, so the only portion of taxes you pay is on the interest earned. This can be a bit complicated in the case of the immediate annuity, but beneficial if you have a significant amount of income to manage.

How the Immediate Annuity Exclusion Ratio Works

The exclusion ratio in an immediate annuity is calculated by dividing the total amount of after-tax money paid for an annuity, or the principal, by the expected return, or total payments. That amount is expressed as a percentage and is applied to each annuity payment to find the portion of the payment that is a non-taxable return of principal. Anything above that amount is considered taxable income in the year you receive it.

Luckily, you’re not expected to calculate the exclusion ratio yourself. When you purchase an annuity contract, the exclusion ratio will be listed in the contract. The life expectancy used to calculate the exclusion ratio will also be listed. Because an insurance company can’t predict life expectancy with complete certainty, there’s always a chance the individual will outlive the life expectancy used to calculate the return of principal.

In that case, it is possible that an annuitant might reach a point where those annuity payments become fully taxable because all of the principal that was initially excluded was paid out. The older the annuitant is when they buy the annuity, the shorter their life expectancy, so the more consolidated those principal payments become.

This can be an excellent move for late retirement planning because it allows you to potentially increase your income in a tax efficient manner. Often, this immediate annuity is funded through the liquidation of a large asset, like if you sell your house or business, or inherit a large sum. In that case, the lump sum you receive will be after-tax income and can be placed in that immediate annuity to help reduce your annuity payment tax burden and potentially lower your tax bracket. Often, a non-qualified immediate annuity, along with Social Security benefits, can help to improve your overall income without increasing your taxes.

How It Works With Social Security Benefits

Payments received from an annuity are not counted as part of your annual income to determine the percent of your Social Security benefits  to be taxed, whether you’re at the minimum or full retirement age. Unlike income from work, which could increase the percent of Social Security that is taxed, income received from non-qualified annuities, dividends, pensions, or investments will not reduce your entitled benefit. A non-qualified annuity could help to reduce how much of your Social Security is considered taxable by reducing your combined income.


Data from “Income Taxes And Your Social Security Benefits”

Your combined income is your adjusted gross income plus any non-taxable interest received and 50% of the total Social Security benefits received. Your gross income is the income you report on your taxes. Non-taxable interest isn’t as simple as it sounds because most interest is taxable. For the purpose of this, the IRS is talking about interest received from any financial or insurance institution in which the recipient was not required to pay taxes, usually due to nonresident alien status. Generally, if you’ve received interest from anything, it was already reported in your gross income for the year. Finally, the 50% of your Social Security benefit is pretty straight forward. It’s half the total amount of Social Security you receive for the year.

The excluded portion of your annuity payment would not be included in this combined income because it’s not considered income for tax purposes. This means your overall combined income is lower, which could mean that you’ll only pay tax on a smaller percentage of your Social Security benefits rather than the whole thing.

Using a non-qualified annuity is a good tactic if you want to increase your income while potentially minimizing your total tax burden. It’s particularly helpful as a supplement to Social Security benefits because it can help to lower the taxable amount on those benefits while still allowing you to supplement them.

At the same time, it’s not ideal if you fear you might need to liquidate that annuity in the future, or if you don’t have provisions in place for your beneficiaries. Once you’re in an immediate annuity, it’s pretty rare that you’ll be able to take a lump sum from the amount or leave anything for beneficiaries through it.

Before making the decision to go with an immediate annuity, it’s important to talk with a financial professional who understands the ins and outs of using these. One of the insurance professionals in Retirement HQ’s extensive network can look at your individual circumstances to see if this is a choice for you to consider.

The information provided in this article is not intended to be legal or tax advice. RetirementHQ can provide information, but not advice related to Social Security benefits. We encourage you to seek guidance from the Social Security Administration, a tax advisor or attorney regarding your particular situation. We are not affiliated with the U.S. Government or any governmental agency.

Distributions from annuities are subject to ordinary income taxes, and if taken prior to age 59-1/2, are subject to an additional 10% federal tax penalty.

By contacting RetirementHQ, you may be offered information regarding the purchase of insurance products. All of our financial professionals are licensed insurance agents. Additionally, some individuals may also be registered with a broker/dealer or as an investment adviser.