Example

James and Shirley, ages 62 and 63 respectively, own a fixed annuity with a level surrender charge of 5% for five years. Their initial single premium was $100,000 and at the end of the third policy year, the annuity value was $115,000. In the third year, an unexpected emergency arises and James and Shirley may need all or most of their money. They called their financial professional to review their choices. Their financial professional informs them they can surrender their annuity and receive $109,250 (in other words, $115,000 minus the 5% surrender charge). Since they are older than 59.5, there will not be a 10% federal excise tax penalty, however, they will have to pay ordinary income taxes of $2,731 on the gain (25% [their tax bracket] times $9,250 of interest earnings equals $2,731 in income taxes). However, since their annuity contract will waive surrender penalties if they annuitize over five years or more, they could apply the $115,000 toward a five year Period Certain settlement option and receive $2,300 a month for 60 consecutive months (five years). When asked to calculate the exclusion ratio, the financial professional simply divided the expected return of $138,000 ($2,300 a month times 60 months) into the initial premium of $100,000 and correctly calculated that 70.2% of the payments would be excludable from income taxes since it represented a return of premium. And, the balance, 29.8% of the payments would be fully taxable.

What can be learned from this example? We learned how to estimate cash surrender value, the impact that taxes can have, and how an exclusion ratio works.