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The advantage lies in something the IRS calls an exclusion ratio. The exclusion ratio is the reason why a portion of each payment is not subject to the income tax when received. It is considered to be the return of the original principal or, if you will, original investment, rather than ordinary income.

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For those who like the trivia behind the ruling, the pertinent section of the Internal Revenue Code is IRC Sec. 72(b). The reasoning is simple. It says that a portion of each annuity payment excluded from income reduces the "unrecovered" investment in the contract.

Once the investment in the contract has been recovered, the rules change. The portions of each annuity payment that were part of the exclusion ratio can no longer be excluded. This makes the whole annuity payment taxable.

Because the payments are based, among other things, on the annuitant's life expectancy, certain other provisions apply. For example, the monthly income stream can be passed on to a beneficiary if the donor dies before payout. The beneficiary would receive the monthly payments for his/her lifetime and would be subject to the rules of the exclusionary rule.

A male aged 65 who annuitizes 0,000 with the intent of passing along this stream of income to his beneficiary would receive 4.67 per month. Of that amount, 9.67 is non-taxable while 5.00 is taxable. The exclusion ratio is 49.40%.

Note: This payout example is specific to one company as of December 28, 2009 and is not to be relied upon other than as an example of an annuity payout. No tax advice is imputed or stated in either the article or the example. Always consult with a tax professional for tax advice.

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Carson E. Koziol