Annuities✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
The exclusion ratio used to determine the tax-free portion of each nonqualified annuity payment is calculated as:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
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.
Why the other options are wrong
- B) Inverting the ratio would treat most of each payment as taxable gain, misstating the basis-recovery principle.
- C) Payments received to date have no role in the ratio; the formula uses the investment in the contract and expected return.
- D) Age and payment frequency affect the expected return calculation but are not themselves the ratio's numerator and denominator.
Memory hook
Exclusion ratio = basis over expected payout. It slices each check into tax-free and taxable.