Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 3/5
Under IRC Section 72(b), the exclusion ratio used to find the nontaxable portion of each annuity payment is calculated as:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
The exclusion ratio is the investment in the contract, the cost basis, divided by the expected total return over the payout period. Each annuity payment is then split: the portion equal to the ratio is a tax-free return of principal, and the remainder is taxable interest income. Once the policyowner's cost basis has been fully recovered, all remaining payments become fully taxable. This ratio is the core of annuity income taxation and must be recomputed if the payout terms change.
Why the other options are wrong
- B) Inverting the ratio would make the nontaxable portion larger than the payment itself, which is impossible; the cost basis belongs in the numerator. The ratio reflects the fact that part of each payment is a return of the owner's own money.
- C) The ratio uses dollar amounts of investment and expected return, not the number of premium payments or the contract term. The correct order is investment divided by expected return, so the basis belongs in the numerator.
- D) Interest credited is part of the expected return, not a separate subtraction; the ratio is the basis divided by the expected return. The exclusion ratio works with dollar amounts of cost and expected payments, not counts of premiums.
Memory hook
Exclusion ratio = cost over expected payout. Each check pays back a slice of principal, tax-free, until the basis is gone.