What term describes the method of determining which part of an annuity payment is taxable and which part represents the tax-free return of the after-tax cost basis?

What term describes the method of determining which part of an annuity payment is taxable and which part represents the tax-free return of the after-tax cost basis?

• A. exclusion ratio
• B. cost basis ratio
• C. payout ratio
• D. tax-deferral method

Answer: (A)

The method is the exclusion ratio. It separates each annuity payment into a tax-free return of the after-tax cost basis and a taxable earnings portion. Here's how it works: because non-qualified annuities are funded with after-tax dollars, part of every payout is simply recovering the money you already paid in (the cost basis) and isn’t taxed again. The rest represents earnings and is taxed as ordinary income. To determine the amounts, you calculate the exclusion ratio by dividing the cost basis by the expected total return from the contract. Multiply each payment by that ratio to find the tax-free portion; the remainder of the payment is taxable. Example: if your cost basis is $50,000 and you expect total payments of $120,000, the exclusion ratio is 50,000/120,000 ≈ 41.7%. For a $1,000 payment, about $417 is tax-free and about $583 is taxable. If the annuity were funded with pretax dollars (a qualified annuity), there’s no tax-free return of principal, so the exclusion ratio effectively would be zero and the entire payment would be taxed as ordinary income.

The method is the exclusion ratio. It separates each annuity payment into a tax-free return of the after-tax cost basis and a taxable earnings portion.

Here's how it works: because non-qualified annuities are funded with after-tax dollars, part of every payout is simply recovering the money you already paid in (the cost basis) and isn’t taxed again. The rest represents earnings and is taxed as ordinary income.

To determine the amounts, you calculate the exclusion ratio by dividing the cost basis by the expected total return from the contract. Multiply each payment by that ratio to find the tax-free portion; the remainder of the payment is taxable.

Example: if your cost basis is $50,000 and you expect total payments of $120,000, the exclusion ratio is 50,000/120,000 ≈ 41.7%. For a $1,000 payment, about $417 is tax-free and about $583 is taxable.

If the annuity were funded with pretax dollars (a qualified annuity), there’s no tax-free return of principal, so the exclusion ratio effectively would be zero and the entire payment would be taxed as ordinary income.