An immediate annuity provides a guaranteed monthly income in exchange for a lump sum of money. This type of annuity typically is used to provide a set amount of guaranteed retirement income. An immediate annuity could also provide tax-advantaged income, under the right circumstances. The exclusion ratio shows what portion of an annuity payment is tax-free income.
After Tax Annuities
An exclusion ratio only applies to immediate annuities purchased with at least a portion of after-tax money. The exclusion ratio is determined from the amount of after-tax money used to buy the annuity. After-tax money could include money from a bank certificate of deposit or the original investment amount in a deferred annuity. If untaxed money such as IRA or 401(k) proceeds are used to buy an immediate annuity, there will be no exclusion ratio, and the annuity payments will be fully taxable.
Exclusion Ratio Factors
The exclusion ratio is the percentage of the annuity payment classifed as non-taxable income. The amount of payment excluded is calculated by dividing the after-tax money used to buy the annuity by the life expectancy of the person receiving the annuity payments. For example, a person age 65 has a life expectancy of 20 years, or 240 months, according to the IRS Table V. If an annuity is purchased with $100,000 of after-tax money, then $100,000 divided by 240 means $416.67 of each annuity payment would be non-taxable. If -- for example -- the annuity payment received is $700 per month, the exclusion ratio would be 416.67 divided by 700, producing a ratio of 59.5 percent.
Obtaining the Exclusion Ratio
The actual exclusion ratio for any immediate annuity will be provided by the insurance company that sold the annuity. The ratio will vary based on the type of annuity payment selected -- such as single life or joint-and-survivor -- and the age of the annuity recipient -- called the annuitant. The older the annuitant is when the annuity is started, the greater will be the exclusion ratio. For an older annuity buyer, the immediate annuity can provide a significant amount of non-taxable income based on the amount used to purchase the annuity.
The exclusion ratio applies until the after-tax money used to purchase the annuity has been completely accounted for as untaxed income. This means that if the annuitant lives past the calculated life expectancy, the annuity payments will at some point become fully taxable. It will be a significant number of years before the annuity payments become fully taxable, but this factor should be included in any retirement income tax planning.