What Is the Exclusion Ratio Used to Determine in Annuities?

The exclusion ratio for an annuity is the percentage of each payment that comes back to you tax-free. You calculate it by dividing your after-tax investment in the contract by the total dollars you expect to receive over the life of the annuity. Whatever percentage that produces is applied to every payment; the rest of each payment is taxed as ordinary income.

The point of the ratio is to separate two things bundled inside every annuity check: a return of the money you originally put in, and the investment earnings that grew on top of it. You already paid tax on your own contributions, so the IRS lets that portion come back to you untaxed. Only the earnings piece is income.

What the Ratio Is Splitting

Section 72 of the Internal Revenue Code treats every payment from an annuity, endowment, or life insurance contract as gross income, except for the share that represents a return of your own after-tax investment.¹ The excluded share is what the exclusion ratio quantifies.

The IRS uses two frameworks. Non-qualified annuities (contracts you bought with after-tax dollars) follow the “General Rule,” which relies on actuarial tables in Publication 939. Payments from qualified plans like pensions, 401(k)s, and 403(b)s use the “Simplified Method,” which replaces the tables with a short list of age-based divisors.² The goal is the same either way: divide each payment into a taxable piece and a tax-free piece.

The Two Numbers You Need

Investment in the Contract

This is the total after-tax money you put into the annuity, reduced by anything you already received tax-free such as dividends or earlier tax-free withdrawals. If you bought a commercial annuity with a single $100,000 lump sum and took nothing out, your investment in the contract is $100,000. For an employer plan, it is generally the sum of your after-tax contributions. Box 5 of Form 1099-R reports the employee contributions or insurance premiums recoverable tax-free for the year.³

Expected Return

This is the total dollar amount you expect to receive over the life of the contract. For a term-certain annuity, multiply the payment by the number of payments. A contract paying $1,000 a month for 15 years has an expected return of $180,000.

For a lifetime annuity, the IRS supplies actuarial multiples in Publication 939. You look up your age at the annuity starting date, find the life expectancy multiple, and multiply it by your annual payment. A 65-year-old with a multiple of 20.0 under Table V who receives $1,200 per year has an expected return of $24,000.⁴

Running the Calculation for a Fixed Annuity

Divide your investment in the contract by the expected return. That is your exclusion percentage, and you apply it to every payment until your basis is fully recovered.

The IRS’s own example in Publication 939 works like this. You purchase an annuity for $10,800 that pays $100 per month for life starting at age 65. The life expectancy multiple is 20.0, so the expected return is $24,000 (20 × 12 × $100). Dividing $10,800 by $24,000 gives an exclusion ratio of 45%. Of the $1,200 you receive each year, $540 is tax-free and $660 is taxable.⁴

Once set, the 45% is locked in. Interest rate changes and adjustments by the insurance company do not move it. You report the gross payment on line 5a of Form 1040 and the taxable portion on line 5b.⁵

Variable Annuities Use a Dollar Amount

Variable annuities do not use a percentage. Because payments fluctuate with investment performance, a fixed percentage would produce a different tax-free dollar amount every month and make basis recovery hard to track. Instead, you calculate a fixed dollar amount that gets excluded from each payment no matter its size.

Divide your investment in the contract by the total number of payments you expect to receive. For a lifetime variable annuity, that count comes from the same actuarial tables, using the life expectancy multiple as the number of expected annual payments. For a 20-year monthly payout, you divide by 240. Anything above the resulting fixed amount is taxable.⁴

In a volatile month this matters. If your variable annuity pays $2,000 one month and $800 the next, the same fixed dollar amount comes out tax-free both times. A low-payment month may be almost entirely tax-free; a high one shifts more into the taxable column.

The Simplified Method for Pensions and 401(k)s

Most people receiving pension or 401(k) distributions never touch the actuarial tables. The Simplified Method replaces them with a divisor based on your age when payments begin. Divide your total after-tax contributions by the number of monthly payments the table gives you to find the tax-free amount per check.⁵

Single-life annuity with a starting date after November 18, 1996:

55 or under: 360 payments
56 to 60: 310 payments
61 to 65: 260 payments
66 to 70: 210 payments
71 or older: 160 payments

Joint and survivor annuity, using the combined ages of both annuitants at the starting date:

110 or under: 410 payments
111 to 120: 360 payments
121 to 130: 310 payments
131 to 140: 260 payments
141 or older: 210 payments

Say you retire at 62 with $39,000 in after-tax contributions. The divisor is 260. That makes $150 of every monthly payment tax-free. If the pension pays $2,500 a month, you report $2,500 on line 5a and $2,350 on line 5b.⁵

The Simplified Method is mandatory for most qualified plan recipients. The General Rule applies to a qualified plan only if the annuity starting date was before November 19, 1996, or if you were 75 or older at the starting date with payments guaranteed for at least five years.⁴

When the Exclusion Stops

The ratio does not run forever. Once the tax-free portions you have received add up to your entire investment in the contract, every payment after that is fully taxable.⁵ In the Simplified Method example above, $150 per month times 260 months equals the full $39,000 in contributions. Month 261 and everything after is 100% taxable, even though your gross payment did not change.

Living longer than the actuarial tables assumed does not extend the exclusion. Once the basis is recovered, it is recovered.

If You Die Before Recovering Your Basis

The reverse case works in your favor. If an annuitant dies before recovering the full investment, the unrecovered portion is deductible on the annuitant’s final income tax return.¹ Publication 575 gives this example: total cost of $12,000, annual exclusion of $1,200, death after year eight. Only $9,600 was recovered, so the remaining $2,400 becomes an itemized deduction on the final return. The deduction is not subject to the 2% adjusted gross income floor, and the statute treats it as attributable to a trade or business for net operating loss purposes.⁵

Withdrawals Before Annuitization Do Not Use the Ratio

The exclusion ratio applies only to amounts received “as an annuity,” meaning the periodic payments after you annuitize the contract. If you take a lump sum or partial surrender from a non-qualified annuity before the payment stream begins, a different rule controls.

Under section 72(e), pre-annuitization withdrawals follow an income-first rule: the IRS treats what you pull out as coming from accumulated earnings before it touches your basis.¹ If your contract has $150,000 in cash value built on a $100,000 investment, the first $50,000 withdrawn is fully taxable. Only after all gains are exhausted do further withdrawals start reducing basis tax-free. That is the opposite of how the ratio works during annuitized payments, and it catches many owners by surprise.

1
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
2
Internal Revenue Service. Topic No. 411, Pensions – The General Rule and the Simplified Method
3
Internal Revenue Service. Instructions for Forms 1099-R and 5498
4
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
5
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income