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Portfolio > Economy & Markets > Fixed Income

Ask the expert : How to explain the exclusion ratio?

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The question was: I am trying to learn how to explain the exclusion ratio in a way my annuity clients will understand. Can you give me a simple explanation to use?

The answer is: “A client’s investment in an annuity is returned in equal tax-free amounts during the payment period. Any additional amount received is taxed at ordinary income rates.

“This means that part of each payment is considered a return of capital and is therefore nontaxable and part of each payment is considered return on capital (income) and is therefore taxable at ordinary rates.

“The formula for determining the nontaxable portion of each year’s payment is, according to the Internal Revenue Code Sec. 72(b)(1):

Investment in the contract
Expected return

“This is called the ‘exclusion ratio.’ It is expressed as a percentage (rounded to three decimal places) and applied to each annuity payment to find the portion of the payment that is excludable from gross income [Treas. Reg ?1.72-4(a)(2)].

“For instance, assume a 70-year-old purchases an annuity. He pays (i.e., the investment in the contract is) $12,000 for the annuity. Assume his expected return is $19,200.

“The exclusion ratio is $12,000/$19,200, or 62.5%. If the monthly payment he receives is $100, the portion that can be excluded from gross income is $62.50 (62.5% of $100). The $37.50 balance of each $100 monthly payment is ordinary income [Treas. Reg ?1.72-4(d)(2)].

“Note, however, that if the annuity starting date is after December 31, 1986, the excludable amount is limited to the investment in the contract. Once that amount is recovered, all future annuity payments are fully subject to ordinary income tax [IRC Sec. 72(b)(2)].

“…Once an annuitant actually lives longer than his or her actuarial life expectancy, 100% of each payment will be taxable.”

There is more to exclusion ratios, but that should give you an overview.

Source: Income Tax Planning, a 2004 book in the Tools & Techniques series published by The National Underwriter Company, Cincinnati, Ohio, page 254. The book is co-authored by Stephan R. Leimberg, Martin J. Satinsky, Michael S. Jackson, Randy Gardnes, Sonya E. King, Joseph F. Stenken, and John H Fenton.


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