Mr. Dayani purchases an annuity with funds from his savings account on January 1, 2020. The annuity has a 5 year term, and cost him $25,000. Payments are made annually on December 31 in the amount of $5,772. The annuity provides an effective yield of 5%. How much of the annuity payment is taxable in 2020?

Question

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The taxable portion of an annuity payment is determined by subtracting the non-taxable return of investment portion from the total payment. The non-taxable portion is calculated based on the exclusion ratio, which is the investment in the contract divided by the expected return. The expected return is the payment amount times the number of payments. Here, $25,000 invested, with annual payments of $5,772 over 5 years, gives an expected return of $5,772 * 5 = $28,860. The exclusion ratio is $25,000 / $28,860. Each year, the non-taxable portion is this ratio applied to the payment amount, and the remainder is taxable. For 2020, the taxable amount is the payment minus the non-taxable portion, which is $772 when rounded to the nearest dollar.

Mr Dayani Purchases an Annuity with Funds from His Savings