550 / How are payments under a variable immediate annuity taxed?

Both fixed dollar and variable annuity payments received as an annuitized stream of income are subject to the same basic tax rule: a fixed portion of each annuity payment is excludable from gross income as a tax-free recovery of the purchaser’s investment, and the balance is taxable as ordinary income. In the case of a variable annuity, however, the excludable portion is not determined by calculating an “exclusion ratio” as it is for a fixed dollar annuity ( Q 527). Because the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. Thus, the excludable portion of each payment is determined by dividing the investment in the contract (adjusted for any period-certain or refund guarantee) by the number of years over which it is anticipated the annuity will be paid.¹ In practice, this means that the cost basis is simply recovered pro-rata over the expected payment period.

If payments are to be made for a fixed number of years without regard to life expectancy, the divisor is the fixed number of years. If payments are to be made for a single life, the divisor is the appropriate life expectancy multiple from Table I or Table V, whichever is applicable (depending on when the investment in the contract was made). If payments are to be made on a joint and survivor basis, based on the same number of units throughout both lifetimes, the divisor is the appropriate joint and survivor multiple from Table II or Table VI, whichever is applicable (depending on when the investment in the contract is made). IRS regulations explain the method for computing the exclusion where the number of units is to be reduced after the first death. The life expectancy multiple need not be adjusted if payments are monthly. If they are to be made less frequently (annually, semi-annually, quarterly), the multiple must be adjusted.²

A portion of each payment is only excluded from gross income using the exclusion ratio until the investment in the contract is recovered (normally, at life expectancy).³ However, if payments received are from an annuity with a starting date that was before January 1, 1987, payments continue to receive exclusion ratio treatment for life, even if the total cost basis recovered exceeds the original investment amount.

Where payments are received for only part of a year (as for the first year if monthly payments commence after January), the exclusion is a pro-rata share of the year’s exclusion.⁴