A client pays $100,000 into a nonqualified annuity and elects a lifetime payment option with total expected payments of $250,000. The monthly payment is $2,000. Using the exclusion ratio under IRC §72(b), what amount of each monthly payment is tax-free?

Why B is correct

Under IRC §72(b), the exclusion ratio is the investment in the contract divided by the expected return: $100,000 ÷ $250,000 = 40%. The tax-free portion of each payment is the payment multiplied by the ratio: $2,000 × 40% = $800 tax-free; the remaining $1,200 is taxable ordinary income. The exclusion ratio applies for life while payments continue, so the owner recovers the cost basis gradually rather than all at once. Once the basis is fully recovered, later payments become fully taxable.

Why the other options are wrong

• A) $1,200 is the taxable portion of the payment, not the tax-free amount; the exclusion ratio gives a 40% tax-free share, which is $800 of each $2,000 payment. Only $800 of each payment escapes tax.
• C) $500 would require a 25% exclusion ratio; the correct ratio is $100,000 ÷ $250,000 = 40%, which produces $800 tax-free per payment. The ratio is 40%, not 25%. $800 is the correct answer.
• D) $1,000 assumes a 50% exclusion ratio, but the ratio is 40% because the $100,000 basis is divided by the $250,000 expected return. The ratio drives the final answer. Use 40%, not 50%.

Memory hook

Exclusion ratio = cost ÷ expected return; 40% of $2,000 leaves $800 tax-free.