Expected Return
For an annuity payout, the total amount anticipated over the payout period, computed from the payment amount and life expectancy (or period certain), used in the exclusion ratio.
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What happens to annuity payments received after the annuitant has fully recovered the investment in the contract?
The remaining payments are fully taxable as ordinary income — Once the annuitant has recovered all basis through the exclusion ratio, subsequent annuity payments are fully taxable as ordinary income. The exclusion ratio applies only while basis remains unrecovered; IRC Section 72(b) provides that if the annuitant outlives the expected return period, all later payments are included in gross income. This is why payments continuing beyond the life expectancy become fully taxable.
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An annuitant invests $100,000 (cost basis) in an annuity contract with an expected total return of $500,000. Under IRC Section 72(b), what is the exclusion ratio used to compute the tax-free portion of each annuity payment?
20 percent, because the basis is 20 percent of the expected return — The exclusion ratio under IRC Section 72(b) is the investment in the contract divided by the expected return: $100,000 divided by $500,000 equals 20 percent. Each annuity payment is 20 percent tax-free and 80 percent taxable. Once the annuitant has recovered the full cost basis through exclusions, all subsequent payments are fully taxable. The ratio applies for the duration of the expected payout.
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