The Exclusion Ratio: How Much of Each Annuity Payment Is Taxable

When an annuity you bought with after-tax money starts paying you monthly income, how much of each check does the IRS tax? Not all of it — part of every payment is simply your own money coming back to you, and you already paid tax on it once. The exclusion ratio is the formula that draws that line.

This article explains how the ratio works under what the IRS calls the General Rule, walks through the arithmetic with a hypothetical example, and covers the cases where the ratio doesn't apply at all. It sits at the junction of two topics worth reading alongside it: how annuitization turns a lump sum into payments and how annuities are taxed overall.

The Idea: Each Payment Is Part Principal, Part Earnings

Suppose you buy an income annuity with money from a regular savings or brokerage account — what the tax code calls a non-qualified annuity, because it sits outside a retirement plan. The premium you paid is your investment in the contract, or basis. It was taxed before you handed it over, so it can't fairly be taxed again on the way back out.

But each payment also contains earnings the contract generated, and those have never been taxed. Rather than make you track which dollars are which, the General Rule spreads your basis evenly across your expected payments. A fixed slice of every check is a tax-free return of premium; the remainder is ordinary taxable income.

The Formula

Exclusion ratio = investment in the contract ÷ expected return.

• Investment in the contract is the after-tax premium you paid, minus any amounts you already received back tax-free (and minus the value of any refund feature, per the IRS worksheets).
• Expected return is the total you're projected to receive. For a fixed-period annuity, that's the payment times the number of payments. For a life annuity, it's the annual payment times a life expectancy multiple from the IRS actuarial tables in Publication 939.

The ratio is set once, at the annuity starting date, and the excluded dollar amount of each payment stays fixed from then on.

A Worked Example

The numbers below are chosen only to make the arithmetic easy to follow — the payment figure is not a quote, and real payouts move with pricing you can check on the live SPIA estimates page.

Say a 65-year-old pays a $100,000 after-tax premium for a straight life annuity, and assume the contract pays $600 a month — $7,200 a year. IRS Publication 939's Table V gives a 65-year-old a life expectancy multiple of 20.0. The math runs:

1. Expected return: $7,200 × 20.0 = $144,000.
2. Exclusion ratio: $100,000 ÷ $144,000 ≈ 69.4%.
3. Tax-free portion each year: $7,200 × 69.4% ≈ $5,000. The remaining ≈ $2,200 is taxable as ordinary income.
4. Basis recovery: at roughly $5,000 of excluded premium per year, the full $100,000 basis is recovered after about 20 years — right at the table's life expectancy, by design.

So in this illustration, less than a third of each check shows up as taxable income during the recovery period. That pro-rata treatment is one of the quieter advantages of annuitizing after-tax money.

Outliving the Tables — and Dying Early

For contracts with an annuity starting date after 1986, the exclusion has a cap: once your cumulative tax-free amounts equal your investment in the contract, the exclusion ends and every subsequent payment is fully taxable. In the example above, payments in year 21 and beyond would be 100% ordinary income. The income itself keeps arriving for life — only the tax split changes.

The reverse case matters too. If you die before recovering your basis on a life-only contract, the unrecovered investment is generally deductible on your final income tax return. Contracts with a cash refund feature or a period-certain guarantee handle the early-death scenario inside the contract instead, by continuing value to a beneficiary.

When the Exclusion Ratio Does Not Apply

The ratio only exists to recover after-tax basis. Where there's no basis — or no annuitization — the rules are different:

That last row is the one that surprises people. Taking free withdrawals from a deferred contract and annuitizing it produce very different tax patterns from the same money — a tradeoff covered in depth in our comparison of annuitization and systematic withdrawals. For the underlying account-type distinction, see what makes an annuity qualified and how non-qualified annuities work.

Three Details Worth Knowing

• It's ordinary income, not capital gains. The taxable slice of each payment is taxed at your regular income tax rate, no matter how the insurer earned it.
• Joint contracts use joint life expectancy. A joint and survivor annuity computes its expected return over two lives, using the joint tables — which stretches the basis recovery over a longer period and lowers the excluded amount per payment.
• Annuitized lifetime payments generally avoid the pre-59½ penalty. The 10% additional tax on early distributions has an exception for substantially equal periodic payments made over your life expectancy, which annuitized lifetime income is designed to satisfy. Confirm your situation with a tax professional.

Next Step: Get the Payment Before You Do the Tax Math

The exclusion ratio is only half the equation — the other half is the payment itself, which depends on live payout pricing. Check current SPIA income estimates and deferred income annuity estimates for your age, then run the ratio on real numbers. IRS Publication 939 has the official tables and worksheets, and a tax professional can confirm how the General Rule or Simplified Method applies to your contract.