Any investment income earned on annuities during the accumulation period is not taxable until distributed to the policyholder with one major exception.

If an annuity contract is held by an entity who is not a natural person (corporation or trust), the annuity taxation rules differ. The income on the contract must be treated as ordinary income received or accrued by the policyholder that year. Annuity benefit payments are a combination of principal and interest. Each payment is considered a partial return of basis and partially taxable income using an inclusion/exclusion ratio
.
a. Exclusion ratio - The numerator for the exclusion ratio is the cost basis in the annuity. The denominator is the total expected benefits.
b. Inclusion ratio - The numerator for the inclusion ratio is the total expected benefit less the cost basis. The denominator is the total expected benefits.

Example: John retired on December 31, 2004, and receives a monthly annuity pension benefit of \$1,000 payable for life. His life expectancy at the date of retirement is 10 years. During his years of employment, John contributed \$30,000 to the cost of his company's pension plan.

Solution: Excluded from John's taxable income in 2005 is \$3,000 (\$30,000 Ã· \$120,000 = .25 or 25% 2005 (12 payments x \$1,000) x Â¼ = \$3,000.

Practice Question:
Tom purchased a single premium immediate annuity for \$100,000 lump sum for his life. Tom will receive a 4% return on his investment for the life of the contract. The insurance company has guaranteed Tom a monthly payment of \$1,200 for the rest of his life. According to actuarial tables, Tom is expected to live another 10 years (120 payments). Which of the following is correct?

A. If Tom dies after receiving only \$75,000 back, his beneficiary will not be taxed on the \$25,000 return of premium.
B. If Tom lives longer than 10 years, all amounts received after the 120th payment must be included in his gross income.
C. If Tom collects \$12,000 in his first calendar year from the annuity, the full payment will be considered a return of principal and not taxable income to Tom.
D. Tom's first monthly payment for \$1,200 will have an exclusion ratio of 96%.

When Tom purchases a single-life immediate annuity, the insurance company will guarantee payments for Tom's life only, so payments will cease at his death. Tom's exclusion ratio will be 69.44% (\$100,000 divided by \$144,000), so a payment for \$1,200 will have \$833.33 excluded from gross income. If Tom lives longer than his 120th payment, all future payments will be includable as gross income. The 4% return is irrelevant for this question.

Introduction

Related Articles
1. Retirement

### Are Annuities Retirement-Only Investments?

Learn more about why annuities are generally purchased and the way that they can positively and negatively affect an individual preparing for retirement.
2. Retirement

### How a Fixed Annuity Works After Retirement

These popular investments can provide a steady stream of income during your retirement years. Here are the details.

### An Overview of Annuities

These contracts provide a guaranteed income stream. Learn how they work and their benefits.

### Advising FAs: Explaining Annuities to a Client

Conceptually speaking, annuities can be thought of as a reverse form of life insurance.
5. Retirement

### Why Are Annuities Important for Retirement?

Understand how annuities work, and identify the benefits they provide for retirement, the most salient being a guaranteed income stream for life.
6. Retirement

### Annuities Vs. Bonds: Which One Is Better For You?

Compare the important features of annuities and bonds, and understand which investment vehicle is the better choice based on retirement goals.
7. Retirement

### Annuities: How To Find The Right One For You

Fixed, variable and indexed annuities offer different features. Find out which one fits your needs.
8. Retirement

### What Is the Best Age to Get an Annuity?

Optimizing the benefits of an annuity means guaranteeing a stream of income you can't outlive.
9. Retirement

### What Role Should Annuities Play in Retirement?

Fixed annuities can provide income protection for those worried about outliving their assets. But don't buy a bigger policy than you really need.