A California resident receives periodic payments from a nonqualified annuity. For California personal income tax purposes, the tax-free portion of each payment is determined:

Why A is correct

California's Personal Income Tax Law conforms to the federal Internal Revenue Code, including IRC §72(b), for calculating the taxable and tax-free portions of annuity payments. A California resident therefore applies the same exclusion ratio (investment in the contract divided by the expected return) for state purposes as for federal purposes. The gain portion of each payment is taxable by California as ordinary income, and the basis-recovery portion is excluded. This conformity avoids double taxation and inconsistent treatment between the federal and state returns.

Why the other options are wrong

• B) California does not use a flat 50% exclusion ratio; it conforms to the federal ratio computed under IRC §72(b), which varies with the contract's numbers. The ratio is never a flat figure.
• C) There is no three-year limitation in California; the exclusion ratio continues to apply until the cost basis is fully recovered over the payout period. It runs for the life of the payments.
• D) California does not exempt all annuity payments; only the basis-recovery portion is excluded, while the gain element of each payment is taxable. The gain portion is always taxed. So part of every payment is income.

Memory hook

Same ratio, both columns: California borrows the federal exclusion ratio.