VALIDACIÓN DE LA PROPUESTA

Payments received after the annuity starting date are known as amounts received as an annuity and are generally taxed under the annuity rules. Under the annuity rules, the purchaser’s investment in the contract is received in equal tax-free amounts over the payment period, and the balance of the payment is taxable income. As a result, each payment received—until the entire investment in the contract is recovered—is comprised of a:

• Tax-free return of investment

and

• Taxable income

Although the basic rule with respect to annuity taxation applies to both fixed and variable annuities, the method of arriving at the portion of each payment that is tax-free as a return of the investment in the contract is somewhat different for them.

Fixed Annuities

In the case of annuity payments received under a fixed annuity, determination of the tax-free portion involves the calculation of an exclusion ratio. The exclusion ratio is then applied to each periodic income payment until the entire investment in the contract is recovered tax free. Periodic income payments received after the entire investment in the contract is recovered are fully taxable.

A fixed annuity’s exclusion ratio is the ratio that the total investment in the contract bears to the total expected return. The exclusion ratio is generally expressed as a percentage and is derived by dividing the investment in the contract by the expected return. For example, if the investment in the contract is $200,000 and the expected return is $300,000, the exclusion ratio would be $200,000 ÷ $300,000 = .667 = 66.7%. If the monthly income under this contract were $2,000, the amount that would be deemed a return of the investment in the contract and, therefore, tax

free is $2,000 x 66.7% = $1,334. The balance of $666 each month would be considered taxable earnings. Of course, if the recipient received only the $2,000 monthly income and had no other income, his or her total annual taxable income would be $666 x 12 = $7,992.

Determining the expected return under an annuity contract is equally simple. We noted earlier that payments received as an annuity may be made under a:

• Temporary annuity

or

• Life annuity

If annuity payments are made under a temporary annuity, i.e. a fixed period or fixed amount annuity, the expected return is simply the sum of the guaranteed payments. If payments are for a fixed number of years, the expected return is the guaranteed amount receivable each year multiplied by the fixed number of years.

For example, suppose the contract owner made a premium payment of $200,000 and arranged for income payments under a fixed period annuity for 10 years. Under the insurer’s fixed period annuity, the contract owner would receive $3,000 each month for 120 months. His or her expected return would be, of course, $3,000 multiplied by the 120 months over which the contract owner will receive it, or $360,000. To determine the amount of each monthly income payment that is tax-free, we need only divide the $200,000 investment in the contract by the $360,000 expected return. By doing that, we determine that 55.6 percent of each $3,000 monthly payment is received tax free as a return of the contract owner’s investment in the contract. ($3,000 x 55.6% = $1,668)

Determining the exclusion ratio under an annuity contract involving life contingencies, i.e. a life annuity, is somewhat more complicated but still not difficult. The determination of the investment in the contract is done in the same fashion; calculating the expected return requires that a life expectancy table be consulted. The two tables that may be consulted to determine the expected return multiple for a single life annuity are Table I or Table V. Table I is a gender- based life expectancy table and is to be used if the investment in the contract does not include an investment after June 30, 1986. Table V is a unisex life expectancy table and is to be used if the investment in the contract includes an investment after June 30, 1986. A portion of Table V is reproduced below.

Table V—Ordinary Life Annuities—One Life—Expected Return Multiples (excerpt)

Age Multiple Age Multiple Age Multiple

55 28.6 64 20.8 73 13.9 56 27.7 65 20.0 74 13.2 57 26.8 66 19.2 75 12.5 58 25.9 67 18.4 76 11.9 59 25.0 68 17.6 77 11.2 60 24.2 69 16.8 78 10.6 61 23.3 70 16.0 79 10.0 62 22.5 71 15.3 80 9.5 63 21.6 72 14.6 81 8.9

If our contract owner that had purchased the 10-year temporary annuity in our previous example had chosen, instead, to purchase a straight life annuity with his $200,000 and he was age 65, he might expect to receive about $2,000 per month for life.

To determine his expected return, we would need to consult Table V (above), and we would find that his expected return multiple was 20.0. (The expected return multiple approximates the individual’s life expectancy.) The expected return multiple must be multiplied by the sum of one year’s payments to determine the expected return. Since we know that the contract owner will receive $2,000 each month, his annual income will be $24,000. By multiplying the annual income by the expected return multiple, we can see that the total expected return under the contract is $480,000.

Calculating his exclusion ratio requires only that we divide the $200,000 investment in the contract by the $480,000 expected return. The exclusion ratio thus calculated is 41.7%. ($200,000 ÷ $480,000 = .417) By multiplying the $2,000 monthly periodic payment by the exclusion ratio, we see that the tax-free portion of each monthly payment is $834. Therefore, $10,008 is excludable each year.

Variable Annuities

Determining the excludable portion of annuity payments received under a variable annuity is somewhat simpler. Although both fixed and variable annuities are subject to the same basic rule, the excludable portion of the payment is not determined through the calculation of an exclusion ratio since the expected return under a variable annuity is unknown. (Remember, variable annuity payments will go up or down depending on the investment performance of the portfolio supporting the annuity units.)

Since the expected return under a variable annuity is unknown, it is considered to be equal to the investment in the contract. So, the excludable portion is calculated by dividing the investment in the contract by the number of years over which the annuity will be paid. If the contract owner that had purchased the fixed life annuity had used his $200,000 to purchase a variable annuity, we would determine the amount of income that was tax free each year by dividing the $200,000 by the 20.0 year expected return multiple. The result would be $200,000 ÷ 20 = $10,000 excludable each year—just about the same amount determined for the fixed annuity.