A formula called the exclusion ratio is used to determine the non-taxable portion of each payment. The exclusion ratio is determined by dividing the net investment in the contract by the expected return.
The investment in contract is the amount paid for the annuity (single premium or total periodic premiums). Expected return is the total amount the annuitant can expect to receive from the contract during the payout period.
| $100,000 Investment in Contract = .40 Exclusion Ratio | $257,680 Expected Return ($14,400 x 17.2) |
This means that 40 percent of each $1,200 monthly payment, or $480, is received tax-free and the remaining 60 percent, or $720, is taxed as ordinary income.
If the annuity payments end with the annuitant's death, no value is included in the annuity owner's gross estate. Any unpaid amounts guaranteed by a period certain or installment refund annuity option, however, must be included in the deceased owner's gross estate for estate tax purposes. The beneficiary will have to pay income tax to the extent that the amount received by the beneficiary, when added to the tax-free amounts received by the annuitant, exceeds the annuity's purchase price (investment in contract).
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