For many retirees, investing in an annuity offers a low-stress way to ensure they receive regular, guaranteed retirement income. However, annuities can have somewhat complex tax rules. For instance, the exclusion ratio describes the method the IRS uses to determine what portion of your annuity income is taxable. Understanding how this calculation works can help you plan ahead for taxes on your annuity.

How Does an Annuity Work?

To understand the ratio, start with the basics of what an annuity is and how it works. There are several types of annuities, but most of them share the same basic setup.

An annuity is a product sold by an insurance company. In most cases, you will make a lump sum payment to the insurance company after enrolling. The insurance company then invests that money and takes on the risks and benefits of investing. The insurance company anticipates making more money from investing your lump sum than it will pay out to you in annuity payments.

Upon reaching the annuitization period, which can be immediate or years after your purchase of the annuity, you will receive regular payments — usually for the rest of your life. Depending on the type of annuity you purchase, you may also receive a guaranteed rate of return.

What Is an Exclusion Ratio?

When you begin to receive your annuity payouts, each payment has two parts: a return of a portion of the principal you paid as well as some of the interest that the investment has earned. If you purchased the annuity with money you have already paid taxes on, then the IRS does not tax the return of principal portion — that would mean you were taxed twice on the same money. However, the IRS does expect to collect taxes on the portion of your annuity payments that comes from interest. This is taxed as ordinary income.

To determine how much of each annuity payment comes from principal and how much comes from interest, the insurance company holding your annuity uses the exclusion ratio. This ratio determines the percentage of your annuity payments that the IRS excludes from your taxable income, since it is considered return of principal.

How Is the Exclusion Ratio Calculated?

The insurance company holding your annuity will calculate your exclusion ratio using your life expectancy (as determined by IRS actuarial tables) and time frame of the payout. The calculation divides your initial investment amount by the total payments you are expected to receive.

Say you purchased a $100,000 annuity; beginning at age 65, you will receive $650 monthly payments for the rest of your life. According to the IRS Table S, a 65-year-old's life expectancy is 17.3658 years. The $650 in monthly payments equals $7,800 in annual payments. The insurer will multiply the annual payments by the life expentancy:

$7,800 x 17.3658 = $135,453.24

From there, the insurer will divide your initial investment of $100,000 by that amount to determine your exclusion ratio:

$100,000 / $135,453.24 = 0.73826

This means your exclusion ratio is 73.826%.

In other words, of each $650 payment, 73.826%, or $479.87, will be excluded from your taxes and you will only owe taxes on $171.13 of each monthly annuity payment.

However, if you outlive the life expectancy of just over 17 years, that will mean that your entire monthly annuity payment is coming from interest rather than principal. From that point forward, you will owe regular income taxes on your entire monthly annuity payment, as there will no longer be any principal to exclude from your taxes.

The Bottom Line

The IRS only taxes the portion of annuity payments that comes from earned interest, not the portion that represents a return of your principal. Understanding how much of each payment may be excluded from taxation can help ensure you know what to expect from your annuity income.