Annuity (Single-Premium Immediate)
Model a single-premium immediate annuity (SPIA) by routing a lump sum from a taxable, tax-deferred, or Roth account to an insurance carrier in exchange for guaranteed period-certain payouts. Tax treatment depends on the funding source: qualified (100% ordinary income), non-qualified (IRC §72 exclusion ratio splits each payout), or Roth-funded (fully tax-free cash flow).
How it works
A SPIA converts a lump-sum premium into a guaranteed income stream for a defined term. Stratum models the premium debit from the advisor-selected funding pool at the start year (or at a separate premium year for deferred structures), then projects per-year payouts with optional COLA indexing. Three tax treatments are supported: qualified (tax-deferred source), non-qualified (taxable source, IRC §72), and Roth-funded (tax-free source). Term length is set as a fixed number of years, the owner's life expectancy, or second-to-die (married households only). If the funding pool is projected to be insufficient at the premium year, the strategy is skipped entirely — no partial funding, no pro-rating. Adjust the premium or strategy order and re-run.
1. Set the Premium and Funding Source
Enter the premium amount and choose the funding source: taxable account (non-qualified), tax-deferred account (qualified), or tax-free account (Roth-funded). For married households, also select the owner (client, co-client, or joint — joint only available for taxable funding). Tax-deferred and Roth accounts are owned by a single person in Stratum's data model, so joint is not available for those sources. The funding type determines the qualification badge in the editor: Qualified (tax-deferred), Non-Qualified (taxable), or Roth-Funded (tax-free).
Example: $300,000 premium from the client's tax-deferred account — labeled Qualified. $200,000 premium from the joint taxable account — labeled Non-Qualified.2. Choose the Term Mode
Three term modes are available. Fixed years: the advisor enters a specific count (minimum 2 years). Owner's life expectancy: payouts run from the start year through the owning spouse's assumed death year. Second-to-die: payouts run through the later of the two spouses' assumed death years — only available for married households with a co-client. Life-expectancy and second-to-die modes resolve to a concrete year count at calculation time using the life expectancy assumptions set in the scenario.
Example: Client born 1959, LE age 90 (death year 2049), start year 2027: owner's LE mode resolves to 2049 — 2027 + 1 = 23 years. Second-to-die with co-client born 1961, LE age 88 (death year 2049): same resolved term of 23 years.3. Set the Annual Payout and Optional COLA
The annual payout is the year-1 amount the carrier pays. If a COLA rate is entered (0—5% is typical), the payout grows by that percentage each year: year N payout = annualPayout x (1 + colaRate)^(N—1). COLA rates outside 0—5% produce a warning; rates outside -10% to +20% are rejected.
Year N Payout = annualPayout x (1 + colaRate)^(N-1)
Example: $24,000/year with 2% COLA: Year 1 = $24,000. Year 5 = $24,000 x 1.02^4 = $25,979. Year 20 = $24,000 x 1.02^19 = $34,251.4. Qualified Annuity Tax Treatment (Tax-Deferred Funding)
When the premium is funded from a tax-deferred account (Traditional IRA, 401(k), etc.), the annuity is qualified under IRC §72(d). Every dollar of the payout is fully taxable as ordinary income — treated as pension income in the projection. The premium debit uses a transfer transaction type, not a distribution, so the move from the tax-deferred account to the carrier does not generate a deemed distribution or additional ordinary income at the debit year. Income begins appearing only when payouts start. Known limitation: if the funding account contains nondeductible contributions (Form 8606 basis), that after-tax basis is not propagated to the annuity. All qualified payouts are modeled as 100% ordinary income regardless of any prior nondeductible contributions.
Example: $300,000 from a Traditional IRA. Year-1 payout $18,000: $18,000 ordinary income, added to pension income on the Tax tab. IRA balance is reduced by $300,000 in the premium year with no tax event at the debit.5. Non-Qualified Annuity Tax Treatment (Taxable Funding, IRC §72)
When the premium is funded from a taxable account, the annuity is non-qualified. Tax treatment is governed by the IRC §72 exclusion ratio: Exclusion Ratio = Premium divided by Expected Return (sum of all COLA-grown payouts over the term). Each year's payout is split: basis recovery = payout x exclusion ratio (tax-free return of premium); taxable portion = payout — basis recovery (ordinary income). Basis accumulates evenly across the term — it is fully recovered at the last payment year with no mid-term crossover under v1's uniform scaling approach. Selling appreciated taxable securities to fund the premium is also a realization event under IRC §1001. Stratum recognizes a one-time long-term capital gain in the premium year equal to the appreciated portion: premium x (1 — basisRatio), where basisRatio is the year-0 ratio of account basis to current value.
Exclusion Ratio = Premium / Sum(annualPayout x (1 + colaRate)^t) for t = 0..N-1 Year N Basis Recovery = Year N Payout x Exclusion Ratio Year N Taxable = Year N Payout — Year N Basis Recovery Premium Capital Gain = Premium x (1 — Basis Ratio of funding pool)
Example: $200,000 premium, $15,000/year payout, 0% COLA, 20 years. Expected return = $300,000. Exclusion ratio = $200,000 / $300,000 = 66.7%. Year 1: $10,000 basis recovery (tax-free) + $5,000 ordinary income. Funding account: $400,000 value / $80,000 basis (20% basis ratio). Premium capital gain = $200,000 x (1 — 0.20) = $160,000 LTCG in the premium year.6. Roth-Funded Annuity Tax Treatment (Tax-Free Funding)
When the premium is funded from a Roth account, the entire payout stream is already after-tax basis. Every payout is cash-flow-only — it appears on the Income tab as spendable income but produces zero ordinary income on the Tax tab. The premium debit reduces the Roth account balance in the premium year.
Example: $150,000 from a Roth IRA. Year-1 payout $10,000: $10,000 on the Income tab, $0 on the Tax tab. Roth balance is reduced by $150,000 at the premium year.7. Binary Funding Check
Real annuity contracts are all-or-nothing — a carrier does not issue a partial contract because the premium came up short. Stratum mirrors this: before applying the strategy, it projects the source pool's balance at the premium year (current balance x (1 + investmentReturn)^yearsUntilPremium). If that projected balance is less than the configured premium, the strategy is skipped entirely — no premium debit, no payouts, no capital gain. A warning chip labeled 'Skipped — Underfunded' appears on the strategy card. To resolve: reduce the configured premium, push the start year later, or reorder strategies so competing draws happen after the annuity funding year.
Example: $300,000 premium. Source pool: $250,000 today, 5% growth, premium year is today. Projected balance = $250,000 — strategy is skipped. Reduce premium to $250,000, or start in 3 years when the projected balance is $289,406.
Real-world context
When Advisors Use a SPIA
A SPIA converts a lump sum into guaranteed income for a defined period. Advisors use it when a client needs a reliable income floor — especially when Social Security and any pension alone are insufficient to cover fixed expenses. It also matters when a client is worried about sequence-of-returns risk: locking in a guaranteed income stream reduces the portfolio draw needed in down markets. The primary trade-off is illiquidity — the premium leaves the client's control at purchase. In Stratum, modeling a SPIA shows the advisor exactly how the annuity income interacts with other sources (Social Security, RMDs, structured withdrawals) and what the net tax cost looks like year by year in both the Base and Strategic cases.
Choosing the Right Funding Source
The funding source has major tax consequences. Qualified (tax-deferred): simplest structure — every payout dollar is ordinary income. Good when the IRA balance is large and the client wants to guarantee income without managing the drawdown themselves. Trade-off: the transfer does not trigger a current distribution, but all future payouts are ordinary income regardless of any nondeductible basis in the account. Non-qualified (taxable): the exclusion ratio shelters a portion of each payout as tax-free basis recovery. Funded by selling appreciated securities, which realizes a capital gain at purchase. Best for clients with low-basis taxable assets who want to convert a capital-gains realization into a partially-sheltered income stream going forward. Roth-funded: zero tax on payouts, but spends down a tax-free account that otherwise grows indefinitely with no RMDs. Generally the least-efficient source unless the client has more Roth assets than needed for other planning purposes.
The Exclusion Ratio in Client Meetings
For non-qualified annuities, the exclusion ratio can be counterintuitive in client meetings. The client receives a payout each year and expects to pay tax on only part of it — because part is return of their own money. The Stratum Tax tab shows this split directly: the taxable portion flows into ordinary income; the basis portion does not appear on the Tax tab at all. The exclusion ratio is fixed for the entire term (uniform scaling). Example: 66.7% exclusion ratio on a $15,000/year payout means $10,000 is tax-free basis recovery and $5,000 is ordinary income every year — easily explainable in a client meeting. The editor's live preview strip shows the exclusion ratio and year-1 split as the advisor enters the premium and payout numbers.
IRS reference: IRC §72; IRS Publication 575 (Pension and Annuity Income)
How Annuity Income Interacts with Other Strategies
The annuity is not auto-mode — it runs in advisor-set order in the strategy pipeline, and the advisor can reorder it via drag-and-drop. For qualified and non-qualified annuities, the taxable portion of each payout adds to ordinary income in those years. Auto-mode Structured Withdrawals and auto-mode Roth Conversion, which always run at the tail of the pipeline regardless of card position, see this annuity income when sizing their draws and conversions. If annuity payouts fill part of a tax bracket, those auto-mode strategies will draw less or convert less — which is the correct behavior. For Roth-funded annuities, payouts are cash-flow-only and do not raise AGI, so they do not consume bracket headroom for Roth conversions or structured withdrawal sizing.
Binary Funding and Strategy Order
If other strategies draw heavily from the same funding pool before the annuity's premium year, the source pool may be depleted below the premium amount. The static funding check uses year-0 balance grown at the investment return rate — it does not see balance reductions from other strategies' draws. When the annuity unexpectedly shows Skipped — Underfunded, check whether other strategies are drawing from the same account before the premium year. Reordering so the annuity funds first, or adjusting the premium amount, typically resolves it. A runtime backstop also performs a live balance check against actual projected balances — if that fires, the warning chip will appear even if the static check passed.
What drives the result
The lump sum debited from the funding pool at the premium year. Higher premium means a larger funding draw and (for taxable sources) a larger capital gain realization at purchase. For non-qualified annuities, higher premium raises the exclusion ratio — more basis is recovered per payout, reducing ordinary income per year. Premium above the projected source pool balance causes the strategy to be skipped entirely.
$300,000 vs. $200,000 premium (same $15,000/year payout, 20-year non-qualified). $300,000 premium: exclusion ratio = 100% (premium equals expected return) — fully tax-free payouts. $200,000 premium: exclusion ratio = 66.7% — one-third of each payout is ordinary income.
Determines the tax treatment of all payouts. Tax-deferred: 100% ordinary income each year. Taxable: IRC §72 exclusion ratio (partial basis recovery per payout) plus a one-time capital gain at purchase. Tax-free (Roth): zero taxable income on any payout.
$200,000 premium, $15,000/year payout, 20 years. Tax-deferred: $15,000/year ordinary income. Taxable (20% basis ratio): ~$160,000 LTCG at purchase, then ~$10,000/year basis recovery + ~$5,000/year ordinary income. Roth: $0 tax, $15,000/year spendable income.
The first year payouts begin and (for SPIA) when the premium is debited. Choosing the retirement year or shortly after aligns guaranteed income with the gap between retirement and Social Security eligibility or RMD age. Can be set as a relative anchor (retirement year, current year, tax year) or a specific year.
Client retires in 2029, Social Security starts in 2034. Annuity start year 2029 fills the income gap for 2029—2033, reducing the taxable or tax-deferred account draw needed during the bridge period.
Fixed years: precise control over the payout window — useful for bridge strategies. Owner's LE and Second-to-die anchor the term to life expectancy assumptions — changing LE in the scenario automatically adjusts the term and the total projected payouts.
5-year fixed term bridges 2029—2033 exactly. Owner's LE mode starting 2029 with client LE age 90 (death year 2049): 21 years of payouts through the client's assumed life.
Year-1 payout amount. For non-qualified annuities, a higher payout for the same premium lowers the exclusion ratio — more of each payment is taxable. The exclusion ratio and year-1 split in the editor's preview strip update live as the payout is changed.
$200,000 premium, 20-year term, 0% COLA. At $12,000/year: exclusion ratio = 83.3% ($10,000 basis / $2,000 taxable). At $20,000/year: exclusion ratio = 50% ($10,000 basis / $10,000 taxable).
Annual growth rate applied to the payout. Raises payouts over time to offset inflation, but also lowers the exclusion ratio for non-qualified annuities — the total expected return grows relative to the fixed premium. Typical SPIA COLAs are 0—3%.
$200,000 premium, $12,000/year base, 20 years. 0% COLA: expected return = $240,000, exclusion ratio = 83.3%. 3% COLA: expected return rises to approximately $321,000, exclusion ratio drops to roughly 62.3% — more of each payout is taxable.
Assumptions
- Life-expectancy and second-to-die term modes use the life expectancy assumptions entered in the scenario (Assumptions tab)
- Investment return used for the binary funding projection is the scenario's global investment return assumption — per-pool growth rates are not separately modeled
- Non-qualified annuity basis recovery uses a uniform exclusion ratio across the entire term — basis does not exhaust mid-term under v1's IRC §72 implementation
- Premium capital gain for taxable funding uses the year-0 basis ratio of the funding pool; this is an approximation for future premium years where the actual ratio may differ slightly
- Qualified annuity payouts are treated as 100% ordinary income regardless of any nondeductible contributions in the source account (Form 8606 basis is not propagated)
- All securities sold to fund a non-qualified premium are assumed to be held long-term (LTCG rates apply to the realized gain at purchase)
- COLA rates are applied as a fixed annual percentage to the year-1 payout with no further cap beyond the hard validation bounds (-10% to +20%)
Limitations
- Form 8606 / after-tax basis in a qualified funding account (IRA or 401(k)) is not propagated to the annuity — all qualified payouts are modeled as 100% ordinary income. Households with nondeductible IRA contributions will see overstated tax on payouts.
- True life-contingent annuities (mortality probability, survival credits) are not modeled — only period-certain structures are supported
- IRC §72 exclusion ratio does not use IRS Publication 939 expected-return multiples; it uses the actual sum of scheduled payouts (uniform scaling). This may produce a slightly different exclusion ratio than the precise IRS annuity tables for life-expectancy-based terms.
- Variable annuities, deferred accumulation-phase growth, GLWB riders, and 1035 exchanges are not modeled
- The premium capital gain approximation for non-qualified funding uses year-0 basis — accounts with high churn or large interim deposits may have a different basis ratio by the actual premium year
- Does not model state-specific annuity income tax treatment beyond the flat state rate in the scenario
- Does not model the 10% early withdrawal penalty for premiums taken from tax-deferred accounts before age 59½
Related
This page explains how Stratum models this calculation. It is educational material for financial professionals, not tax or legal advice, and tax law changes. Verify current figures against primary IRS sources before relying on them with a client.