Chelsey Tucker graduated with a Bachelor of History degree from Metropolitan State University in 2019. She now writes about insurance with her specialty being life insurance and has been quoted on Help Smart Phone and MEL Magazine.

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Dan Walker graduated with a BS in Administrative Management in 2005 and has been working in his family’s insurance agency, FCI Agency, for 15 years. He is licensed as an agent to write property and casualty insurance, including home, auto, umbrella, and dwelling fire insurance. He’s also been featured on sites like Reviews.com.

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Reviewed by Daniel Walker
Licensed Auto Insurance Agent

UPDATED: Mar 19, 2020

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An annuity exclusion ratio is the portion of an annuity payout that is not subject to tax. One of the benefits of having an annuity is the annuity exclusion ratio which allows the account holder to earn the return on their investment tax-free.

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This rate will be designated by a percentage. It determines how much is taxed and how much is not. Make sure you investigate the different types of annuities available before committing to anything.

How is the annuity exclusion ratio determined?

The annuity exclusion ratio is represented by a percentage. The division of the initial investment and the anticipated return determines the exclusion ratio.

For example if you make an investment of 20,000 toward the contract, with a life expectancy of 20 years, and decide on a $1,500 monthly payout, with an anticipated return of $30,000, the percentage for the exclusion ratio is 66.6%. Therefore 66.6% is the nontaxable part of the $1,500 which equals $999.

A variable annuity follows different rules in determining the exclusion ratio. This type of annuity uses the amount of investment and divides it by the number of payments. In this case if you invest the same $20,000 with an anticipated life expectancy of 20 years with a monthly payout of $1,500, the number of payments will equate to 240 and the exclusion ratio will be 83.3%.

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What happens to the other part of the payout?

The other part of the payout is subject to the standard tax rate. In the above example that would equate to $501. This amount will be taxed just like income. Ten percent of the taxable amount is assessed with early distribution. The account owner must hold the contract for 5 years to avoid early distribution charges.

Variable annuities are subject to several maintenance fees and expenses. The taxable amount is also subject to a ten percent fee in a transfer of ownership. Gift annuities are charged a ten percent fee as well. There are some exceptions however. If the account is in the annuitization phase and the owner dies, the remaining amount becomes a tax deduction on the deceased person’s final tax return.

How long is the annuity exclusion ratio applied to my payout?

The exclusion ratio is applied to your account until the presumed life expectancy expires. It is at that time that the whole amount is taxable at standard tax rates. Since October 21, 1988 annuities are consolidated under one account contract if the contract is between the same company and policyholder. This is for the purpose of tax distribution. There are some exceptions and they are:

  • Annuities already in the payout phase
  • Immediate annuities
  • Payouts initiated as a result of the policy holders’ death

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May I change the annuity exclusion ratio?

The only way the exclusion ratio changes is in the case of death. The beneficiary can continue the payments as they were or they may increase the payout amount which will in turn change the exclusion ratio. This number will more then likely increase since the beneficiary has five years to cash out in most cases.

Certain groups of people have more flexibility to implement change such as:

  • Doctors
  • Teachers and other school personnel
  • Hospital employees
  • Non-profit organizations

These groups of people are eligible to participate in group annuities. They can make changes to their accounts without the penalties of individual annuities. Employers make contributions to these accounts while social security is withheld.

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What if I out-live my life expectancy?

Not only will your checks be taxable at 100%, on a fixed annuity the payments are stopped. In most cases, the funds revert to the insurer. In some cases, you can name a beneficiary. If so, your beneficiary will have to claim the remainder of the annuity on your taxes if the payout phase has begun. If not, the five year window of opportunity is applied. The beneficiary can set up the payment options as they deem it suitable as long as they cash out in five years.

There are some exceptions to the five year rule as well. If the owner of the account dies during the accumulation phase the payout can be paid as per the life expectancy of the beneficiary. If the contract account is a joint account, the clock stars and time is taken into consideration upon the death of the first owner.

Where to Find More Information on the Annuity Exclusion Ratio

Annuities are a complex subject. There are several varieties and exceptions to the standard types. For further explanation of an annuity exclusion ratio click on the free tool, enter your zip code, and get free annuity quotes now!