Under a non-qualified annuity, interest is taxed after the exclusion ratio has been calculated.

• A. True
• B. False
• C. Not applicable
• D. Depends on age

Answer: (A)

In a nonqualified annuity, you fund the contract with after-tax dollars, so part of each payout is a tax-free return of your principal and the rest represents earnings that are taxable. The amount that can be excluded from tax is determined by the exclusion ratio, which is calculated at the outset using the amount invested in the contract and the expected total return (often based on life expectancy). Once that exclusion ratio is established, a portion of every payment is excluded as a return of principal, and the remaining portion is taxed as interest income. So, the interest portion is taxed after applying the exclusion ratio. That’s why this statement is true.