Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 3/5
An annuitant invests $100,000 (cost basis) in an annuity contract with an expected total return of $500,000. Under IRC Section 72(b), what is the exclusion ratio used to compute the tax-free portion of each annuity payment?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
The exclusion ratio under IRC Section 72(b) is the investment in the contract divided by the expected return: $100,000 divided by $500,000 equals 20 percent. Each annuity payment is 20 percent tax-free and 80 percent taxable. Once the annuitant has recovered the full cost basis through exclusions, all subsequent payments are fully taxable. The ratio applies for the duration of the expected payout.
Why the other options are wrong
- B) Five percent is the reciprocal of the correct ratio; the exclusion ratio is the basis divided by the expected return, not the other way.
- C) Annuity payments are not fully tax-free; only the portion representing the return of the cost basis is excluded.
- D) An exclusion ratio does apply to life annuities, so the statement that no ratio applies is incorrect.
Memory hook
Exclusion ratio = your money back, divided by the pot. 100k into 500k = one-fifth tax-free each payment.