What is Your Annuity Exclusion Ratio – and How Could It Affect Your Retirement Tax Liability?

When it comes to annuities, people can have many questions. “What is the annuity exclusion ratio?” is a common one, especially for those considering immediate annuities. Many investors also ask about how the exclusion ratio may affect their tax burden in their retirement. 

The exclusion ratio is an important number. It helps calculate the amount in each of your income benefit payments that won’t be taxable. Several investors like to know its basic ins-and-outs so they can get an idea of what their taxes will be.  

What many people don’t know is that the annuity exclusion ratio may, in fact, reduce their overall tax liability. Since taxes can take a big bite out of retirement income, it certainly can pay off to understand this number and how it might impact you.

How Non-Qualified Money Plays into the Picture

Just like with a Roth IRA and its after-tax status, non-qualified annuities are bought with after-tax dollars. Since you already paid taxes on your money on the front end, much of your income benefit payments will be non-taxable. So, if you bought an annuity with money from a brokerage account, for example, you would have an exclusion ratio.

Starting an annuity with taxable account dollars isn’t the only scenario where portions of your income payments will be non-taxable. It also applies when people buy a non-qualified annuity out-of-pocket, or even with money outside of a tax-deferred retirement account. A certain proportion of every income benefit payment you received would be considered a payback of your principal. As a result, you would have an exclusion ratio and part of each income payment wouldn’t be taxable.

Now, if you paid for an annuity from a traditional IRA or another tax-deferred retirement account, it’s a different story. You won’t have an exclusion ratio because taxes were initially deferred on the full sum of money. Each of your income benefit payments will be 100% taxable. These conditions also apply if, using a 1035 exchange, you swapped an annuity for a new immediate annuity.

The point is the exclusion ratio will potentially lessen your tax liability on your annuity income payments. Since you were already taxed on the principal, the interest you have earned is the only thing that will be taxable. This can be advantageous for tax efficiency purposes, especially if you will be drawing on substantial income streams in retirement.

How Does the Annuity Exclusion Ratio Work?

Here’s how the exclusion ratio of an immediate annuity is determined. Take the total sum of after-tax dollars you paid into the annuity — or your principal — and divide it by the total amount of payments you expect to receive. The resulting percentage rate is what would be your exclusion ratio. This percentage rate specifies the amount of each income benefit payment that is exempt from taxes. The remaining portion of the income payment is what will be taxable.

Now, it’s time to use some numbers so things are easier to understand. Let’s assume that someone has put $20,000 toward their immediate annuity contract. We will also assume that their total payments per year will be $1,500 and their life expectancy is 20 years. That would bring the total amount of payments we expect they will receive to $30,000.

Since the total amount of expected payments is $30,000, the annuity exclusion ratio for this immediate annuity is 66.7%. This would mean that the non-taxable part of each income payment will be equal to 66.67% of $1,500, which comes to $1,000.50. 

What About the Other Part of My Income Payment?

Income taxes will be applied to the remaining part of your annuity payout. If we consider the above example, the taxable portion of each income payment would be $499.50. You can estimate this taxable portion by subtracting the non-taxable portion of an income benefit payment from the total amount of an income benefit payment.

In this case, it’s $1,500-$1,000.50= $499.50. This is the amount that is taxable for the year you receive the income payout.

How Long Does the Exclusion Ratio Apply to Annuity Payments?

When you buy an immediate annuity, the exclusion ratio is stated in the contract. Some insurance companies use the term “taxation ratio” in their contracts, but this means the same thing.

The insurance company will include your life expectancy in its calculations. Your exclusion ratio will apply for the duration of your life expectancy. Of course, some people will outlive their expected lifespans.

In that case, all of the principal will have been paid out. From that point, every income payment might become 100% taxable because the tax-excluded money was exhausted.

Note that there’s a relationship between aging and payment amounts here. The older someone is when they get an annuity, the shorter their expected lifespan will be, and the more substantial their income benefit payments will be. The insurance company will give bigger income payments to older annuity buyers because it has a smaller time-frame for paying back the principal. 

What are Some Retirement Planning Opportunities with the Exclusion Ratio? 

We talked about how a non-qualified annuity may be purchased out of other sources than a Roth IRA. For instance, money can come from an inheritance or sale of a home. Among entrepreneurs planning for retirement, it may come from a company selloff.

In these scenarios you would be dealing with after-tax income. Putting money into an immediate annuity could help you increase your income while lowering your retirement tax burden. In fact, a non-qualified immediate annuity can help enhance your overall income, reduce taxable income on Social Security benefits, and supplement other income sources.

Instead of buying an immediate annuity for lifetime income, some people purchase one for short-to-medium-term income goals. For example, a retiree may purchase an immediate annuity for a 5-year payout period. Once 5 years have passed, the payments would cease. In these shorter-term contracts, the payout period is used to calculate the total amount of expected income payments you would receive.

As the contract expiration date approaches, new annuity purchases can be timed so that date is pushed out further. This could help with increasing income while lowering potential tax burden over an extended timespan.

Now, back to Social Security benefits. Depending on a number of factors, as much as 50-85% of your Social Security benefit payments could be taxable. This Quick Guide to Social Security Taxes in Retirement covers the taxable implications of benefits in depth, but let’s go into a little bit of detail here.

How the Exclusion Ratio can Help Improve Social Security Benefits

When calculating the taxable portion of Social Security benefits, the IRS looks at three things: 

• Adjusted gross income
• 50% of the amount of Social Security benefit payments for the year
• Tax-exempt interest

Adjusted gross income is the figure you give on your tax return. 50% of Social Security benefits refers to half of the value of the benefit payements you will receive for the year. Tax-exempt interest refers to unique tax-free interest you may receive from financial institutions. A common example is interest earned from municipal bonds.

The figures from these three areas are added together. Whether this total sum exceeds certain income amounts determines whether Social Security benefits will be taxable, and if so, how much of the benefits.

The excluded parts of your annuity income payments wouldn’t be included in this total income sum. That is because your annuity payments aren’t considered income for the point of taxability. As a result, your total combined income will be smaller, and therefore the amount of benefits you pay taxes on may be smaller. In fact, with other income planning strategies, you may be looking at even less overall tax liability.

Final Thoughts

Before you buy an annuity, it’s important to consider anything in the context of your financial situation and goals. A non-qualified immediate annuity should make sense in the tax implications of your other income sources. Once your money is in the contract, chances are you won’t be able to take it out in a lump sum. If you plan to use the contract for income purposes, any legacy goals with that money may be diminished or no longer possible. Any annuity should also make sense in the scope of your overall liquidity needs. A financial professional can help you with navigating these factors and other important variables.

It’s prudent to work with a financial professional who understands retirement and how annuities can help — or hinder — your situation. Financial professionals stand ready at SafeMoney.com to give personal guidance to you.

Use our “Find a Financial Professional” section to connect with someone directly. If you need a personal referral, call us at 877.476.9723.