Annuitants’ investment in an annuity is returned in equal tax-free (return of capital) amounts during the payout phase. Any additional amount received is taxed at ordinary income rates. This means each payment consists of two parts: the first part is considered return of capital and is therefore nontaxable, while the second part of each payment is considered return on capital (income) and is therefore, taxable at ordinary rates.
The amount of each period’s payment that will be considered nontaxable is determined by the exclusion ratio. The exclusion ratio is expressed as a percentage, applies to each annuity payment equally through the payout phase, and is calculated as follows:
“Investment in the contract” is defined as the consideration paid for the contract (i.e., the premium) less any amounts received back from the insurer that were income tax free. Premium cost does not include any premiums paid for: (a) waiver of premiums; (b) disability income; or (c) accidental death (“double indemnity”).
“Expected return” is defined as the aggregate payments the annuitant can be expected to receive under the annuity contract. In other words, expected return is the sum of the guaranteed payments if (a) payments are for a fixed period, or (b) if payments are of a fixed amount with no life expectancy. If payments are for the life (or lives) of the annuitant(s), then expected return is the sum of one year’s annuity payments multiplied by the life expectancy of the live or lives involved.
Example. Assume a seventy-year-old purchases an annuity. He pays (the investment in the contract is) $12,000 for the annuity. Assume his expected return throughout the payout phase is $19,200.
The exclusion ratio is $12,000/$19,200, or 62.5 percent. If the monthly payment he receives is $100, the portion that he can exclude from gross income is $62.50 (62.5 percent of $100). The $37.50 balance of each $100 monthly payment is ordinary income.
The full amount of each annuity payment received would be tax-free if the investment in the contract exceeds the expected return (i.e., when the exclusion ratio would be greater than or equal to 100 percent).
The excludable portion of any annuity payment may not exceed the unrecovered investment in the contract (unless the annuity started before January 1, 1987). The unrecovered investment in the contract is the policyowner’s premium cost, reduced by any dividends received in cash or used to reduce premiums, and by the aggregate amount received under the contract on or after the annuity starting date to the extent it was excludable from income. Thus, the unrecovered investment in the contract is reduced each time an annuity payment is made, by the amount of the payment that is excluded from income by the exclusion ratio. This rule limits the total amount the policyowner can exclude from income to the total amount of his contribution. Once an annuitant has fully recovered his investment in the contract, which generally occurs at the end of the expected payout term, 100 percent of each subsequent payment will be taxable. Payments can continue beyond the expected payout term when the annuitant actually lives longer than his or her actuarial (expected) life expectancy.
Some annuities provide a refund if the annuitant dies before recovering his entire cost. The present value of the refund option must be ascertained by government tables and subtracted from the investment in the contract. This would also apply if the annuity payout phase incorporated a combined life expectancy and term certain structure.
The expected return is the total amount that the owner (or owners) should receive given the payments specified (which include an assumed internal growth rate) multiplied by the certain term or life expectancy according to the government’s tables.
The taxable portion of annuity payments is considered investment income that may be subject to the 3.8 percent Net Investment Income tax (NIIT) depending on the annuitant’s level of income. However, because annuities are often used to defer taxation until later in life when the annuitant’s income is otherwise likely to be lower, the NIIT may not be an important factor in annuity planning.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM