serves to increase the cash value of the annuity. No income is recognized by the annuitant at the
time the cash value of the annuity increases because the taxpayer has not actually received any
income. The income is not constructively received because, generally, the taxpayer must cancel
the policy to receive the increase in value (the increase in value is subject to substantial
The tax accounting problem associated with receiving payments under an annuity contract is one
of apportioning the amounts received between recovery of capital and income. The annuitant can
exclude from income (as a recovery of capital) the proportion of each payment that the investment
in the contract bears to the expected return under the contract. The exclusion amount is calculated
as follows: (Investment/ Expected Return) x Annuity Payment = Exclusion.
The expected return is the annual amount to be paid to the annuitant multiplied by the number of
years the payments will be received. The payment period may be fixed (a term certain) or for the
life of one or more individuals. When payments are for life, the taxpayer generally must use the
annuity table published by the IRS to determine the expected return. The expected return is
calculated by multiplying the appropriate multiple (life expectancy) by the annual payment.
The exclusion ratio (investment / expected return) applies until the annuitant has recovered his or
her investment in the contract. Once the investment is recovered, the entire amount of subsequent
payments is taxable. If the annuitant dies before recovering the investment, the unrecovered cost
(adjusted basis) is deductible in the year the payments cease (usually the year of death).
The taxpayer's expected return is $300 x 12 x 20.8 = $74,880. The exclusion percentage is .
667735, rounded to 66.77%, ($50,000 investment/$74,880). The expected return is $2,403.72
(66.77% x $3,600 annual payment). The $2,403.72 is a nontaxable return of capital, and $1,196.28
($3,600 - $2,403.72), rounded to $1,196 is included in gross income.
Tax Drill - Annuities
A taxpayer, age 64, purchases an annuity from an insurance company for $50,000. She is to
receive $300 per month for life. Her life expectancy 20.8 years from the annuity starting date.
Assuming that she receives $3,600 this year, what is the exclusion percentage and how much is
included in her gross income?
Round the exclusion percentage to two decimal places. Round the final answer for the income to
the nearest dollar.