An annuitant paid $100,000 into a nonqualified annuity, and the contract's expected total return is $200,000. Under the exclusion ratio method, each annuity payment is:

Why A is correct

The exclusion ratio is the annuitant's cost basis divided by the expected total return under the contract. Here, $100,000 divided by $200,000 equals 50 percent, so half of each payment is treated as a tax-free return of the investment and the remaining half is taxable as ordinary income. Once the total cost basis has been fully recovered, which normally occurs when the annuitant lives beyond the actuarial expectation, later payments become fully taxable. The ratio is fixed at the start of annuitization and applies for the life of the payout stream.

Why the other options are wrong

• B) A 100 percent exclusion would mean the entire expected return is treated as a return of principal, which cannot be correct when the contract's expected payout is twice the amount invested. Only half of the expected payments represent recovered cost.
• C) The ratio cannot exceed 100 percent because the numerator, the cost basis, is smaller than the denominator, the expected return. A fully taxable result would ignore the return-of-principal component entirely.
• D) A 200 percent rate is meaningless under the exclusion ratio method, which only divides principal recovery from income. No tax system applies a rate based on the relationship between cost and expected return.

Memory hook

Exclusion ratio = cost divided by expected payout. Here 100 over 200 = half free, half taxed.