Annuity Income Exclusion Guidelines – Paul Gaulkin CPA

money that is locked with chainAn annuity is nothing more than a contract that pays a fixed income at set intervals for a specified period of time. The amount of income generally depends upon the premium paid, the life expectancy of the annuitant, and the number of years payments are to be received.

When income is received as an annuity under an annuity, endowment, or life insurance contract, the amount received generally consists of two separate parts:

1. A nontaxable return on the investment made by the annuitant
2. A taxable amount representing the gain on the investment

Under special rules for the taxation of income received as an annuity and paid out for reasons other than the death of the insured, the tax free portion of the annuity income is divided evenly over the taxpayer’s lifetime. This also applies to payments that are to be made for a defined number of years.

The Exclusion Ratio

Basically, the excludable portion of an annuity payment is the annuity payment times the exclusion ratio. The exclusion ratio is defined as the investment in the contract divided by the expected return under the contract as of the annuity starting date.

The formula for determining the excludable portion of an annuity payment is basically:

Amount of exclusion = Total payment for the year X (Investment in the contract / Expected return for the life of the contract)

Once the exclusion ratio has been determined, one of the following two sets of rules must be applied depending on the individual’s annuity start date:

1. Annuity start date prior to 1987 – The exclusion ratio is applied every year there is a payment, regardless of whether the taxpayer lives beyond the life expectancy.

2. Annuity start date after 1986 – The exclusion ratio is applied to payments until the total exclusions equal the investment in the contract. All payments received after this date is fully taxable to the taxpayer.

Once the formula has been applied correctly depending on the taxpayer’s specific situation, the excludable portion will be evident.

About Paul Gaulkin CPA

Paul Gaulkin is a Certified Public Accountant and enrolled with the U.S. Treasury to practice before the IRS. Mr. Gaulkin possesses unique technical knowledge in the process of securing relief for taxpayers nationwide with IRS and State tax problems. With an accounting degree from Florida International University, he is able to transform complex tax and accounting problems into easy to understand solutions.


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