# How to Figure the Taxable Portion of Annuities

Shawn Plummer

CEO, The Annuity Expert

As one navigates the winding roads of financial planning, the terrain of annuities often appears fraught with complexities. One of the most asked questions about annuities is: What method determines the taxable portion of annuities? This question is pivotal and potentially impactful on your financial planning.

## Breaking Down Annuities

First, it’s crucial to comprehend what annuities are and how they function. An annuity is a financial product insurance companies offer, primarily utilized to generate a steady income stream during retirement. When you purchase an annuity, you make either a lump-sum payment or a series of payments. In return, the insurance company commits to making periodic payments to you immediately or at a designated date.

## Navigating Annuity Taxation

One significant aspect of annuities that tends to puzzle investors is taxation. More specifically, how is the taxable portion of each annuity payment calculated? Before we delve into this, it’s essential to understand that the taxability of annuity payments hinges on various factors, such as the type of annuity (qualified or non-qualified) and the funding source (pre-tax or after-tax dollars). The determination of the taxable portion follows IRS guidelines.

## General Rule: The Exclusion Ratio

The taxable portion of each annuity payment is typically calculated using a method known as the exclusion ratio. This ratio determines the amount of each annuity payment deemed a tax-free return on your initial investment. The remaining portion is viewed as earnings and, therefore, subject to tax.

## Delving Deeper: Applying the Exclusion Ratio

To illustrate how the exclusion ratio works, let’s consider a hypothetical scenario. Suppose you invested \$100,000 in a non-qualified annuity and have already received \$20,000 in tax-free income. Here, your investment in the contract is \$80,000 (\$100,000 – \$20,000). Let’s assume you’re to receive a \$5,000 annuity payment. In this case, the exclusion ratio would be 80% (\$80,000 divided by \$100,000). This means that 80% of your \$5,000 annuity or \$4,000 is tax-free. The remaining \$1,000 is taxable.

## Making Sense of Annuity Taxation

The exclusion ratio is a fundamental concept that governs the determination of the taxable portion of each annuity payment. However, it’s important to remember that tax rules may vary based on the specifics of your annuity contract and personal circumstances. Consulting with a financial advisor or tax professional is advisable to ensure you’re making the most of your annuity investment.

## Next Steps

To wrap up, determining the taxable portion of each annuity payment might seem intimidating at first glance. However, with a clear understanding of the method involved – the exclusion ratio, you’re better equipped to navigate this critical aspect of annuity management. The key lies in appreciating the nuances of your annuity contract and applying the tax rules judiciously to secure your financial future.

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## Frequently Asked Questions

### What portion of an annuity is taxable?

The taxable portion of an annuity is typically determined based on the investment gains portion of each payment, while the original investment portion is generally not subject to taxation.

### How is the taxable portion of each annuity payment calculated?

The taxable portion of each annuity payment is calculated based on the proportion of investment gains versus the original investment, following the IRS guidelines and the annuity’s exclusion ratio.

### What is the general rule for taxable annuity?

The general rule for taxable annuities is that the portion of each payment representing investment gains is taxable. In contrast, the original investment portion is typically not subject to taxation.

Shawn Plummer

CEO, The Annuity Expert

I’m a licensed financial professional focusing on annuities and insurance for more than a decade. My former role was training financial advisors, including for a Fortune Global 500 insurance company. I’ve been featured in Time Magazine, Yahoo! Finance, MSN, SmartAsset, Entrepreneur, Bloomberg, The Simple Dollar, U.S. News and World Report, and Women’s Health Magazine.

The Annuity Expert is an online insurance agency servicing consumers across the United States. My goal is to help you take the guesswork out of retirement planning or find the best insurance coverage at the cheapest rates for you.

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