A regular question we receive is: Are annuity payments taxable? Typically, at least a portion of an annuity payment is taxable.* Taxpayers should be careful to distinguish between the portion that represents a nontaxable return of the amount paid for the annuity and the taxable portion.
To do this, the taxpayer generally divides the original, after-tax contribution by the expected return on the date the annuity begins. The cost/payout ratio, or “exclusion ratio,” is then multiplied by each installment payment to determine the nontaxable amount.
Example. Mary paid $10,800 for an annuity that will pay her $100 per month for 20 years. Mary’s expected return is $24,000. The exclusion ratio is 45% ($10,800/$24,000). For each $100 installment, $45 will be nontaxable, and the remaining $55 will be taxable.
Note that the expected returns on annuities may vary with the amount and the measuring term. Where the measuring term is someone’s lifetime or joint lifetimes, the IRS has tables for determining the expected return.
With variable annuities, the payout may vary based on such things as investment performance or changes in a particular index. Generally, the exclusion ratio is calculated by dividing the cost of the annuity contract by the total number of anticipated payments. However, if the nontaxable portion exceeds the actual payment, the taxpayer may elect to recompute the exclusion ratio for later years.
Individuals sometimes receive all or a portion of the money in their qualified retirement plan accounts as an annuity. Such annuities are referred to as “qualified” annuities, and the method for calculating the exclusion ratio is similar to those described above. Note, however, that if the account assets consist entirely of pretax salary contributions (and earnings on those contributions), the exclusion ratio will be zero, and each installment will be fully taxable.