Exclusion Ratios

Exclusion ratio is the proportion of an annuitized payment that is a return of capital and therefore not taxed. It determines how much of each annuity payment is excluded from income tax and how much is taxable when income is received. Also the ratio of taxable to nontaxable proceeds in an immediate annuity payment is called exclusion ratio. It is a very important terminology in an annuity that needs to be understood properly.

If the annuity contract is annuitized in which the annuitant receives the payouts after the completion of a specified period of time for life time or the maturity of annuity, then the part of each payment is considered as a return of previously tax principles and rest of the parts are considered as earnings and the taxpayer owe the income taxes on this payment or earnings.
The amount of an annuity payment that is not subject to income tax when received, since it is considered to be the return of the original principal. An account with a large amount of credited interest will have a lower exclusion ratio than a mostly principal payout.

Non-qualified or after tax monies used to purchase annuity income have something qualified plans do not. The exclusion ratios and the amount of the annuity are not considered taxable. These are considered not only the return of interest but also of the original principal amount. The cost basis or principal is the original investment and is not subject to income tax when distributed from a Personal Income Annuity.

For example, if a 60 year old male with $100,000 and a cost basis of $50,000 purchases an annuity income for life the payment would be $594 per month of which 29% would be tax free.

If that same 60 year old had a cost basis of $100,000 the payment is still $594 per month however, the exclusion ratio would be 58%.