How pension annuity income is taxed: the exclusion ratio

One of the quietly attractive things about a pension annuity bought with after-tax savings is that only part of each check is taxable. The mechanism has an intimidating name — the "exclusion ratio" — but the idea is simple and fair.

You already paid tax on the principal

If you fund the annuity with non-qualified (after-tax) money — savings, a CD, a brokerage account — you already paid income tax on that money once. The IRS won't tax it again. So when the insurer sends your monthly check, it splits it into two parts: a return of your own principal (not taxed) and the interest earned (taxed).

What the exclusion ratio does

The exclusion ratio is simply the fraction of each check that counts as your returned principal — the tax-free part. On the calculator's results you'll see a smaller "taxable" figure next to each payout: that's the interest portion, the only slice the IRS touches. The rest arrives tax-free until you've received back all your original principal.

The IRA exception

If instead you fund the annuity with qualified money — a traditional IRA or 401(k) — the whole check is taxable, because that money was never taxed going in. Neither approach is "better"; it just depends on which bucket the money comes from. A tax advisor can help you decide, and it's worth doing before you buy.

This is general education, not tax advice — confirm your specifics with a tax professional.