Which method determines the taxable portion of each annuity payment?

• A. Exclusion Ratio
• B. Pro Rata Method
• C. Interest-Only Method
• D. Combined Method

Answer: (A)

The key idea is distinguishing how much of each annuity payment is a tax-free return of your prior after-tax investment versus how much is earnings that are taxable. The Exclusion Ratio does exactly that. It’s calculated once at the start by comparing how much you’ve invested in the contract with the total amount you’re expected to receive. The portion of each payment that matches this ratio is excluded from tax (return of principal), and the remainder is taxed as ordinary income (earnings inside the contract). Over time, as you recover more of the principal, the taxable portion grows.

If the contract is funded with after-tax dollars in a nonqualified plan, there is a basis to recover tax-free; the Exclusion Ratio allocates that tax-free portion to each payment. If the plan is funded with pre-tax dollars (a qualified plan), there’s typically little to no basis, so payments are largely taxable as they come in. Other methods aren’t used to determine the taxable portion of annuity payments in standard practice, which is why the Exclusion Ratio is the correct, accepted approach.