So you’re looking into exclusion ratios for immediate annuities, SPIAs, also known as Single Premium Immediate Annuities. In essence, the short answer to the exclusion ratio is that, with immediate annuities lifetime income stream, you're going to get a combination of return of principal plus interest based on your life expectancy at the time you make the payment. I'm going to dig deeper and explain how exclusion ratios work.
Today we are talking about single premium immediate annuities, which are also called income annuities. A pension annuity. It's the granddaddy of all annuities. This is the one that was first developed in Roman times for the Roman soldiers and their families as a lifetime income stream.
There are a couple of things you should know. The first is that immediate annuities are based on your life expectancy. This is very simple, the older you are, the higher the payment. People say, "Hey, what's the best time to buy an immediate annuity?" I don't know that because it's life expectancy-based. Do interest rates play a role? Yes, secondary. Let's talk about that because that's what you're asking about, the exclusion ratio. So life expectancy is the primary pricing mechanism. And number two is interest rates. People tend to flip those, and they say it's all about interest rates, not life expectancy. It's not. With an immediate annuity, it's about life expectancy, rates play a role, and there's no way to time it.
The other day a guy called me up and said, "I'm not sure I want to buy an immediate annuity because I'm going to wait until rates go up." And I'm like, “that's a good idea. But if you do that, then you have to factor in the payments that you missed while you were waiting." That makes rational sense, right? The point is, and this isn't some bad sales pitch, you can't time it. You can't beat the annuity company at their own game. Life insurance companies have those significant buildings for a reason because they know when you're going to die.
The exclusion ratio applies regardless of what account you have it in. Still, if you have an immediate annuity in a Roth account, the income stream is tax-free because it's inside of a Roth. Suppose it's inside an IRA, a traditional IRA, or something like that. That income stream is taxable at ordinary income rates because it's inside of your IRA.
Let's talk about the exclusion ratio in a non-IRA, non-qualified setting. It will be principal plus interest. Let's just say the principal amount is $1,500 and the interest amount is $500. You're going to get the $2,000 a month for life if there's a lifetime guarantee, but you're only going to pay taxes on 500 of that. So what they're going to do is spread out that tax liability over your life expectancy.
Now, what happens when the account goes to zero, and you've outlived your life expectancy? The company is still on the hook to pay you, but all of that amount is taxable. So the exclusion ratio applies as long as there's money in the account. Once it goes to zero, the income stream continues uninterrupted and unchanged, but all of the money is taxable.
Because rates change every seven days, they don't live in perpetuity. For example, you can get a payment every month for 20 years, and you can set it up monthly, quarterly, semi-annually, and annually. And this ratio applies. So why do we have the 20 years specific there? Because a lot of people want what I call a backstop with some guarantees beside it. But let's just say your Learjet hits the mountain year five, you've got five years of payments, and at year five, poof, you're gone. What does that mean? There are 15 more years of payments to your beneficiaries. So if you live 21 years and die, there is simply no more money for the beneficiaries.
Now, it doesn't have to be life and 20. It could be life and 10, life and five, life and 30. There are customizable quotes, but the exclusion ratio still applies, regardless of the annuitized product, instead of an immediate annuity, deferred income annuity, or QLAC, which is a deferred income annuity inside of an IRA. Exclusion ratios apply, but inside of an IRA, as I said before, all of that income stream is taxable. Our quotes show the total amount of income, the principal, and the interest so that you can see that breakdown and the taxation of the income stream, which is essential in your planning.
Never forget to live in reality, not the dream, with annuities and contractual guarantees! You can use our calculators, get all six of my books for free, and most importantly book a call with me so we can discuss what works best for your specific situation.