50+ Lifestyles

Exclude Income from Taxes

By Richard J. Schillig, CLU, ChFC, LUTCF
Independent Insurance and Financial Advisor

Income tax season is upon us again!! As we deal with 2011 income taxes and compile all that stuff needed to complete tax returns, we are also being inundated with lots of media coverage on the potential of various tax increases on federal, state and local. Often overlooked in planning is a provision of the federal tax code dealing with the income tax treatment of immediate annuities. All annuities are income tax deferred – a big advantage with today’s income tax environment. But in addition to just deferral, the tax treatment of non-qualified immediate annuities holds an additional huge advantage.

The IRS divides all payments received from a non-qualified immediate annuity into two parts: a non-taxable portion that represents return of capital and a taxable portion that represents the earnings on that annuity. As a result, a portion (i.e., the portion representing premiums paid) is excluded from gross income. This portion of each annuity payment that is excluded is determined by multiplying each payment by an ‘exclusion ratio.’ This fixed immediate annuity exclusion ratio is what’s huge – let’s look at that ratio. This ratio is determined by dividing your investment in the annuity by the expected return. For example – you have a fixed immediate annuity that pays you $200 monthly for 20 years. Do the math $200 X 12 = $2,400 X 20 years = $48,000. Your investment in the contract is $24,000 divided by $48,000 = 50 percent exclusion ratio. This means 50 percent of each $200 payment ($100) is excluded from gross income. The rest of the payment ($100) is treated as ordinary income.

Just a caution here, too – rules are different for variable immediate annuities. Since variable immediate annuity payments fluctuate in value, it is impossible to estimate the expected return at the starting date of the variable annuity. Since I am not licensed to provide variable annuities, I am using only the fixed (non-variable) immediate annuity in this example.

In today’s lower interest environment, impacting monthly income plus the terrific advantage of the exclusion ratio, I normally recommend immediate annuities for a much shorter period of time – usually five to seven years. The exclusion ratio on this shorter time-period is greatly enhanced. Let’s look at an example with the minimum allowable time period of five years. An amount of $25,000 invested in a five-year immediate annuity today, will provide $419 monthly income for 60 payments (five years). The same formula applied to a five year immediate annuity is $419 X 60 payments = $25,140. Initial investment $25,000 divided by $25,140 = 99 percent exclusion ratio.

This is a fantastic tax advantage to consider in your planning. Just as there are investment alternatives to protect assets from risks, immediate annuities are alternatives you may utilize to help minimize the income tax bite. Lower income taxes results in higher monthly income – a very nice benefit. Let us help you determine appropriateness of this strategy for you. Call us for details.

Beginning in February, we will resume our “Choices” dinner workshops. The next workshop is scheduled for Thursday evening at 6 p.m. at Bennigan’s in Bettendorf. At these workshops, we review the risks we face in life enhanced in our retirement. One of the risks to income is taxes. Remember the higher the tax, the lower the income. The exclusion ratio is one of the strategies we discuss at our workshops. I encourage you to attend our workshops to hear of this strategy and other strategies we use to manage and protect assets safely for our clients. See our ad below.

Happy Valentines Day!

Richard J. Schillig, CLU, ChFC, LUTCF is an Independent Insurance and Financial Advisor with RJU and Associates, Inc. He can be reached at
(563) 332-2200.