Goal understands the Champions League holders have monitored the 19-year-old, along with Barcelona, Chelsea and Manchester City, prompting an improved contract offer which the player has agreed to.
Sterling has emerged as a key player for Liverpool and England in 2014, but Ancelotti does not feel the winger would strengthen an attack already boasting the likes of Cristiano Ronaldo and Gareth Bale.
"Sterling is a player of great quality, certainly one of the best in Europe," he told The Sun on Sunday. "But we already have extraordinary talent here.
"To think of another striker for the Real Madrid attack is really extremely difficult. It's clear that Sterling is not in our plans."
Sterling, who has three goals and two assists to his name already this season, is expected to line up against Real Madrid on Wednesday as Liverpool host the Spanish giants in the Champions League.