Which method is used to calculate the taxable portion of each annuity payment?

• A. Exclusion Ratio
• B. Pro Rata Basis
• C. Tax Credit Method
• D. Simple Interest Method

Answer: (A)

The exclusion ratio is used to determine how much of each annuity payment is taxable. It calculates the tax-free portion of a payment (the return of your investment) by taking your investment in the contract and dividing it by the contract’s expected total return. The resulting ratio tells you what fraction of every payment is excluded from income, with the remainder taxed as ordinary income. For example, if you invested $40,000 and the insurer expects a $160,000 return, the exclusion ratio is 40,000 / 160,000 = 0.25. Each payment would have 25% tax-free (return of principal) and 75% taxable. Note that this applies to nonqualified annuities funded with after-tax dollars; qualified plans don’t use this ratio in the same way.