Exclusion Ratio
When and if the owner annuitizes (applies their annuity value toward a settlement option), the annuitant can receive equal payments. How will the owner pay taxes on the payments? Will they be fully taxable like withdrawals? No. An exclusion ratio is applied to each payment received. What is an exclusion ratio? A percentage of each payment is considered a return of the owner's cost basis and is tax-free. The balance is taxable. How do you calculate this exclusion ratio? You divide the expected return into the total of all premiums paid into the contract. For example, assume that one year ago I bought an annuity for $80,000. It is now worth $88,000. What is the total of all premiums paid in the contract? Yes, $80,000. Let's further assume that I wish to annuitize and I elect the settlement option of a 5 year Period Certain (60 months) where monthly payments will be $1,667.00 a month. What is my expected return? $100,000 ($1,667.00 times 60 months) is my expected return. Therefore, 80% of all payments I receive are income tax free ($80,000 ÷ $100,000 = 80%). With options using a life contingency, you must calculate their life expectancy using government tables to determine the expected return. Will a percentage of each payment be tax-free forever? No, effective with all annuity starting dates after 12-31-86, payments become fully taxable after the owner recovers the total of all premiums paid into contract (determined by adding all dollars excluded from taxes). In other words, after they have lived beyond their expectancy (as calculated when payments began), payments then become fully taxable.