Payments from variable annuities generally receive the same tax treatment as conventional fixed-dollar annuities. Thus a portion of each payment received by the taxpayer is considered a recovery of the taxpayer s cost or investment in the contract, while the balance is income for tax purposes. The exclusion ratio principle used for conventional annuities also applies to variable annuities. However, while the investment in the contract is determined in the usual way, the expected return is not known in advance because of the variable feature. Therefore the investment in the contract is merely prorated over the life expectancy of the annuitant or over the term of the contract, as the case may be, to determine the excludible portion.
Any excess amount received is includible in the annuitant s gross income.
If the annuitant lives longer than his or her life expectancy, the full amount of the annuity payment is includible in income. If the annuitant receives less than the prorated investment in the contract in a given year, a deductible loss is not allowed. However, the annuitant s exclusion ratio for the remaining years of his or her life expectancy can be recalculated. As its name implies, the variable annuity is likely to produce income payments of differing amounts. However, even if monthly payments drop below the excludible amount, the balance of the exclusion is not lost.