Exclusion Ratio

The investment in the contract divided by the expected total return — Under IRC Section 72(b), the exclusion ratio equals the investment in the contract (cost basis) divided by the expected total return. Each annuity payment is multiplied by this ratio to determine the tax-free portion; the remainder is taxable gain. The ratio spreads the recovery of basis evenly over the expected stream of payments, so the owner is not taxed on money that is simply being returned.

National insurance concept

20 percent, because the basis is 20 percent of the expected return — The exclusion ratio under IRC Section 72(b) is the investment in the contract divided by the expected return: $100,000 divided by $500,000 equals 20 percent. Each annuity payment is 20 percent tax-free and 80 percent taxable. Once the annuitant has recovered the full cost basis through exclusions, all subsequent payments are fully taxable. The ratio applies for the duration of the expected payout.

National insurance concept