What is the exclusion ratio in life insurance?

“The exclusion ratio is $12,000/$19,200, or 62.5%. If the monthly payment he receives is $100, the portion that can be excluded from gross income is $62.50 (62.5% of $100). The $37.50 balance of each $100 monthly payment is ordinary income [Treas. Reg ?1.72-4(d)(2)].

“Note, however, that if the annuity starting date is after December 31, 1986, the excludable amount is limited to the investment in the contract. Once that amount is recovered, all future annuity payments are fully subject to ordinary income tax [IRC Sec. 72(b)(2)].

“…Once an annuitant actually lives longer than his or her actuarial life expectancy, 100% of each payment will be taxable.”

There is more to exclusion ratios, but that should give you an overview.

Source: Income Tax Planning, a 2004 book in the Tools & Techniques series published by The National Underwriter Company, Cincinnati, Ohio, page 254. The book is co-authored by Stephan R. Leimberg, Martin J. Satinsky, Michael S. Jackson, Randy Gardnes, Sonya E. King, Joseph F. Stenken, and John H Fenton.

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The annuity exclusion ratio is a rule created by the Federal Government to help protect taxpayers from having to pay taxes on their annuities annually. The Annuity Exclusion Ratio basically says that if you have a qualifying annuity, you can make a one-time withdrawal up to a certain percentage of your account balance, and it will be tax-free. As long as withdrawals are made over the course of your life expectancy, you will not have to pay any federal income taxes on them. Another way of looking at it is that the annuity exclusion ratio gives you a one-time tax break that lets you use some of your retirement savings with no immediate tax consequences.

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Under the federal annuity exclusion ratio, you can withdraw up to a certain percentage of your account balance each year without incurring any immediate – or deferred – taxes on it. In other words, if you have an annuity that is based on a fixed rate [of return], you will pay no taxes on any withdrawals that are based on that interest rate, over the course of your life expectancy.

Why Do You Need to Know This?

Knowing how an annuity exclusion ratio works is important because it can help you reduce the amount of money you pay in taxes each year. It can also save you a huge amount of money since there is no limit to how much money you can save in an annuity. Additionally, the annuity exclusion ratio allows you to get even more out of your retirement savings by allowing you to take advantage of compounding interest without incurring any taxes on it. As a taxpayer, this gives you two options when withdrawing from your retirement savings. You can take the standard approach of taking distributions that are taxed annually. Or you can use your annuity to receive tax-free income over the course of your life instead, which means less money will be paid out in taxes each year.

Calculating Your Annuity Exclusion Ratio 

The exclusion ratio for a fixed income annuity with a defined payment schedule is rather straightforward to compute. A basic example is that of refinancing a mortgage. The amount of the payment will be set in advance, and it will be paid out over a certain length of time. As a result, the ratio of principle to income is constant. Variable annuities, on the other hand, have unpredictable payments. This is due to the volatility of variable annuities. In the case of a lifetime annuity, this is owing to an unknown length of time. You calculate the exclusion ratio in a standard, fixed-period annuity contract for a lifetime annuity. However, you will have returned the whole original investment at some time. The exclusion ratio will fall below at this stage, and the entire income of the annuity will be taxable. On a specific and set date, the investment will mature. Given the fact that a lifetime annuity is defined as an investment for which you can receive income throughout your life, there’s just uncertainty about how long and if the investor will get revenue past the expiration of the exclusion ratio. Because the variable annuity is exposed to the market, it works differently than most investment products. The exclusion ratio can be derived by dividing the original amount by the payment period. This figure is deducted from the taxable income of each segment, after which anything over that amount is taxed as normal. Say, for instance, you bought a variable annuity with a 20-month payment period for $200. To calculate your exclusion ratio, divide your original investment by the number of payouts, or $200 divided by 20. Every month, your exclusion ratio would be $10; anything greater would be taxed as income. If your annuity underperforms this exclusion ratio, you can rollover the amount and declare it as a loss.

The Bottom Line

Understanding your annuity exclusion ratio will make it easier to manage the taxation of your investments. It also becomes simpler to work with an advisor on any sort of transaction after you know what’s taxable and what isn’t. You can get a good idea of how much return you expect out of your annuity by using online calculators that provide tax-free calculations. You can also call your broker or check annuity rates online, and see what sort of tax-free rate you might be able to expect so that you’re not surprised by increased tax liabilities. The annuity exclusion ratio offers a significant amount of control over the income stream from your annuity as well as how much money is available to you when you turn 65. You can use it to ensure that your income will remain stable until the end of your life, but only if you know how it works.

How do I claim my annuity exclusion ratio?

When you file your taxes, the IRS allows you to supplement your income with tax-free money from a pension or annuity. To do this, simply use Form 1040 and the total of all contributions being made to your plan. You will need a copy of a letter from the company that issued the plan, as well as the form 1099-R from your retirement account.

Does an annuity exclusion apply to an IRA?

The IRS allows for taxes to be deferred on IRA accounts, but you will need to pay taxes when taking distributions. However, if you withdraw from your retirement savings before reaching 59 1/2 years old, you will have to pay a 10% penalty as well as income tax on the funds being distributed.

How does an annuity exclusion ratio work in real life?

Let's say you have $100,000 in your retirement savings plan. If given the option, you could always take out $50,000 every year for five years to supplement your income. While this would be taxed annually, it also means that you can give yourself a known amount of money each year.

What is the importance of knowing your annuity exclusion ratio?

Knowing your annuity exclusion ratio allows you to organize your finances. Instead of having to pay taxes on every additional $1,000 that you earn each year, you can instead take out $50,000 from your retirement savings and be able to use it in any way you'd like each year. While you will have to pay income taxes on this, it is better than paying additional taxes each time you earn an extra $1,000.

What numbers do I need in order to calculate my annuity exclusion ratio?

You will need to know the amount of your original investment and the length of your payments. You can then divide the amount of your original investment by the number of installments in order to determine your annuity exclusion ratio.

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