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What Is the Exclusion Ratio?

Stan Haithcock
August 20, 2023

Hi, Stan The Annuity Man, America's annuity agent, licensed in all 50 states. Today's question is a good one. "Hey, Stan, what's this exclusion ratio thing I've heard about? What's an exclusion ratio? Why are they excluding it? I don't want anything excluded. I want it all, Stan. I want it all with my annuity type." We're going to talk annuity types, about the exclusion ratio, how to look at that, and how to navigate my website.

Okay, exclusion ratio, what is that? It revolves around annuities that provide lifetime income. These annuities include Single Premium Immediate Annuities, Deferred Income Annuities, and annuities that are in essence, annuitized. Not all lifetime income stream payments are annuitized. Income Riders can be a draw-down product. Draw down means subtraction in the South. But we'll talk today about exclusion ratios and how to look at that on my site when you run quotes at The Annuity Man and what that means.

Lifetime Income Products

So, what exactly is an exclusion ratio? Let's go backward a little bit and let's focus on two primary products for lifetime income that are both annuitized: Single Premium Immediate Annuities and Deferred Income Annuities. There's also a third one called Qualified Longevity Annuity Contracts that are, in essence, a Deferred Income Annuity but only used for IRAs. But for today's conversation, we'll discuss Immediate Annuities and Deferred Income Annuities. And you say, "Wait a minute, what's the difference?" It's pretty much the same chassis, but the difference is when you turn on the income stream. So, with a Single Premium Immediate Annuity, that income's going to turn on in a year or less. So, 30 days up to a year. With a Deferred Income Annuity, it's really the Immediate Annuity that magically becomes a Deferred Income Annuity after that year deferral. You can defer it for 13 months, five years, 30 years, 10 years, seven years, etc; Deferred Income Annuity. Now with lifetime income payments with annuities, that lifetime income payment is a combination of return of principal plus interest. And you say, "Wait a minute. Whoa, whoa, whoa. Return to my principal plus interest, what?" Yeah, that's what a lifetime income stream is. And the true benefit proposition of an Immediate Annuity and a Deferred Income Annuity is it will pay you for life. We can also structure it so that 100% of any unused money goes to the beneficiaries when you die.

But as long as you're breathing and/or on a respirator, it will pay for as long as you live. But remember what I said, a combination of return of principal plus interest. Now let's go and look at all the types of accounts you can use Deferred Income Annuities and Immediate Annuities in. These accounts are Non-IRA, IRA, and Roth IRA. Let's look at Roth IRA. SPIAs and DIAs in a Roth IRA are tax-free income because you've already paid the taxes on the Roth to convert it. On IRA, SPIAs, and DIAs both, the income coming out of both of those with IRA assets, that income stream's going to be fully taxable because, like everything you pull out of your IRA that's been deferring when you take money out, it's taxable at ordinary income levels.

Non-IRA Assets

But the exclusion ratio truly applies when you're using non-IRA assets, checking accounts, savings accounts, non-IRA, non-qualified as they call it in the business assets. And when you run a quote at our site, you can run an Immediate Annuity quote or a Deferred Income Annuity quote using non-qualified assets. Or let's just say you want to use IRA money and you want to know what the exclusion ratio is. Run it non-qualified, non-IRA. You'll see the grid come up, and it'll show the top companies that have the highest payouts available for your specific situation. You have to understand that the older you are, the higher the payments, as it's primarily based on life expectancy, but it will segment out; here's your lifetime income payment, and here's the interest portion of that.

Life Expectancy

Let's say the lifetime income payment is $2,000 a month and non-qualified. It will show you that maybe $400 of that is interest. So, if you go to the end of the year and pay taxes, you will only pay taxes on the interest portion, the exclusion ratio portion of that lifetime income, in a non-IRA account. People always say, "Well, wait a minute, lifetime income, return of principal plus interest, shouldn't I just watch the FED all the time to see how that's working and time it and try to find the sweet spot or the arbitrage moment to buy it?" No, because the life expectancy part drives the pricing train. The older you are, the higher the payment; the younger you are, the lower the payment just because it's life expectancy based.

The Interest Rate Bogey

But if you wanted to say, "Stan, what's the interest rate kind of bogey that I need to look at?" It's probably the 10-year treasury on that exclusion ratio part. Now that's not 100% math correct because it's a commodity product, and these companies bid on your business based upon the tranche they want to fill with your age range, but that gives you a good feeling of what that interest part will be. Now when you buy an Immediate Annuity with non-IRA money, and you buy a Deferred Income Annuity with non-IRA money, and you know what that exclusion ratio will be, you've locked it in. It won't fluctuate or move up and down. That's it, period. So, let's look at those types. Once again, remember you can buy these in IRAs and Roth IRAs as well, but we're talking about the exclusion ratio, which is primarily the non-IRA portion.

What Happens When It Goes to Zero?

So, let's say you bought an Immediate Annuity or Deferred Income Annuity, and you know what the exclusion ratio is, which is that interest portion of which you will be paying taxes on every year. But let's say you live forever. For 20-plus years, you've been paying taxes every year on that interest portion. "Hey, Stan, what happens when the annuity goes to zero in value, and I'm still getting the payments? Is there still an exclusion ratio?" The answer is no. At that point in time when there's zero in the account, and you're still getting that income stream because that's the transfer of risk benefit, then all of that income's going to be taxable. But only once you get to zero. Until then, you're only paying taxes on that interest portion. Not the principal in a non-IRA setting. So, when we get back to the original question, what is the exclusion ratio? It applies to everything that's annuitized, Single Premium Immediate Annuities, Deferred Income Annuities, and Qualified Longevity Annuity Contracts; all of them are a return of principal plus interest, but the exclusion ratio applies from a taxation standpoint when you're using non-IRA assets.

I know I threw a lot at you, but I explained it very simply because I'm from the South, and that's what we do. But if you have questions, go to my site. You can download my annuity owner's manuals for free, which include PDFs on Deferred Income Annuities, Immediate Annuities, Qualified Longevity Annuity Contracts, and more. You can also schedule a call with us and listen to my podcast.

We're here to educate you, but you will fully understand the exclusion ratio before you buy anything. You're going to fully understand what's taxable based upon the account that you're using. We're going to explain all of that and then leave you alone to make your decision on your terms and on your timeframe. I hope that helped, and I hope that clarifies things. I'm sure it did, and I look forward to speaking with you. I'll see you on the next Stan, the Annuity Man blog.

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