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The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
expected return is $121,200. The exclusion percentage is ($125 × 12 × 23.3). Mary's investment in the contract of
51.7% ($62,712 ÷ $121,200). Gerald will receive $500 a $22,050, divided by her expected return of $34,950,
month ($6,000 a year). Each year, until his net cost is re- equals 63.1%. Each payment received will consist of
covered, $3,102 (51.7% of his total payments received of 63.1% return of cost and 36.9% taxable income, until her
$6,000) will be tax free and $2,898 ($6,000 − $3,102) will net cost of the contract is fully recovered. During the first
be included in his income. If Gerald dies, his wife will re- year, Mary received three payments of $125, or $375, of
ceive $350 a month ($4,200 a year). If Gerald hadn't re- which $236.63 (63.1% × $375) is a return of cost. The re-
covered all of his net cost before his death, his wife will maining $138.37 is included in income.
use the same exclusion percentage (51.7%). Each year,
until the entire net cost is recovered, his wife will receive Increase in annuity payments. The tax-free amount re-
$2,171.40 (51.7% of her payments received of $4,200) mains the same as the amount figured at the annuity start-
tax free. She will include $2,028.60 ($4,200 − $2,171.40) ing date, even if the payment increases. All increases in
in her income tax return. the installment payments are fully taxable.
However, if your annuity payments are scheduled to in-
Example 3. Using the same facts as Example 2, ear- crease at a definite date in the future, you must figure the
lier under Different payments to survivor, you are to re- expected return for that annuity using the method descri-
ceive an annual annuity of $4,800 until you die or remarry. bed in section 1.72-5(a)(5) of the regulations.
Your two daughters each receive annual annuities of
$1,800 until they reach age 18. Your husband contributed Example. Joe's wife died while she was still employed
$25,576 to the plan. You are eligible for the $5,000 death and, as her beneficiary, he began receiving an annuity of
benefit exclusion because your husband died before Au- $147 per month. In figuring the taxable part, Joe elects to
gust 21, 1996. use Tables V through VIII. The cost of the contract was
$7,938, consisting of the sum of his wife's net contribu-
Adjusted Investment in the Contract tions, adjusted for any refund feature. His expected return
as of the annuity starting date is $35,280 (age 65, multiple
Contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,576 of 20.0 × $1,764 annual payment). The exclusion percent-
Plus: Death benefit exclusion . . . . . . . . . . . . . . . . . . . 5,000 age is $7,938 ÷ $35,280, or 22.5%. During the year, he re-
Adjusted investment in the contract. . . . . . . . . . . . . . . $30,576 ceived 11 monthly payments of $147, or $1,617. Of this
amount, 22.5% × $147 × 11 ($363.83) is tax free as a re-
The total expected return, as previously figured (in Ex-
turn of cost and the balance of $1,253.17 is taxable.
ample 2 under Different payments to survivor), is
Later, because of a cost-of-living increase, his annuity
$169,680. The exclusion percentage of 18.0% ($30,576 ÷
payment was increased to $166 per month, or $1,992 a
$169,680) applies to the annuity payments you and each
year (12 × $166). The tax-free part is still only 22.5% of
of your daughters receive. Each full year, $864 (18.0% ×
the annuity payments as of the annuity starting date
$4,800) will be tax free to you, and you must include
(22.5% × $147 × 12 = $396.90 for a full year). The in-
$3,936 in your income tax return. Each year, until age 18,
crease of $228 ($1,992 − $1,764 (12 × $147)) is fully taxa-
$324 (18.0% × $1,800) of each of your daughters' pay-
ble.
ments will be tax free and each must include the balance,
$1,476, as income on her own income tax return. Variable annuities. For variable annuity payments, fig-
ure the amount of each payment that is tax free by divid-
Part-year payments. If you receive payments for only
ing your investment in the contract (adjusted for any re-
part of a year, apply the exclusion percentage to the first
fund feature) by the total number of periodic payments
regular periodic payment, and multiply the result by the
you expect to get under the contract.
number of payments received during the year.
If the annuity is for a definite period, you determine the
If you receive amounts during the year that represent
total number of payments by multiplying the number of
12 payments, one for each month in that year, and an
payments to be made each year by the number of years
amount that represents payments for months in a prior
you will receive payments. If the annuity is for life, you de-
year, apply the exclusion percentage to the first regular
termine the total number of payments by using a multiple
periodic payment, and multiply the result by the number of
from the appropriate actuarial table.
payments the amounts received represent. For instance, if
you received amounts during the year that represent the Example. Frank purchased a variable annuity at age
12 payments for that year plus an amount that represents 65. The total cost of the contract was $12,000. The annu-
three payments for a prior year, multiply that amount by ity starting date is January 1 of the year of purchase. His
the 15 (12 + 3) payments received that the year. annuity will be paid, starting July 1, in variable annual in-
If you received a fractional payment, follow Step 5, dis- stallments for his life. The tax-free amount of each pay-
cussed earlier. This gives you the tax-free part of your to- ment, until he has recovered his cost of his contract, is:
tal payment.
Investment in the contract. . . . . . . . . . . . . . . . . . . . . $12,000
Example. On September 28, Mary bought an annuity Number of expected annual payments (multiple for age 65
contract for $22,050 that will give her $125 a month for from Table V). . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
life, beginning October 30. The applicable multiple from Tax-free amount of each payment ($12,000 ÷ 20). . . . . . $600
Table V is 23.3 (age 61). Her expected return is $34,950
Page 8 Publication 939 (December 2018)
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