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income does not include that part of any amount received as an
annuity which bears the same ratio to such amount as the
investment in the contract (as of the annuity starting date)
bears to the expected return under the contract (as of such
date). Sec. 72(b)(1). This ratio is referred to as the
exclusion ratio. Sec. 72(b). Section 72(c), as relevant here,
defines the investment in the contract to be the aggregate amount
of premiums or other consideration paid for the contract. The
expected return referred to above is determined by multiplying,
at the commencement of the annuity, the total of the annuity
payments to be received annually by a multiple based on the
annuitant’s age and sex. Sec. 1.72-5(a)(1), Income Tax Regs.
The application of the exclusion ratio to each annuity
payment determines the amount excluded from the gross income of
the annuitant and, thus, the amount is not subject to Federal
income tax. This excluded amount represents that part of the
annuity payment which accounts for the return of the annuitant’s
investment in the annuity. The exclusion ratio operates to
exclude from gross income taxpayer contributions over the entire
period of the annuity. Kirkland v. Commissioner, T.C. Memo.
1994-220. The tax-free portion of the pension annuity payment is
computed using either the Simplified Method or the General Rule.
See generally Internal Revenue Service Publication 575, Pension
and Annuity Income, and Internal Revenue Service Publication 939,
General Rule for Pensions and Annuities.
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Last modified: May 25, 2011