Exclusion Ratio

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Exclusion Ratio

The percentage of an investor's return that is not subject to taxes. The exclusion ratio is a percentage with a dollar amount equal to the payback on one's initial investment. Any return above the exclusion ratio is subject to taxes. Most of the time, the exclusion ratio applies to non-qualified annuities.
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On top of that, the $375,000 donation will yield $519,000 of income to the donor over their lifetime, and because of exclusion ratios contained in nonqualified annuities, the income tax due on the annuity income will be reduced further until the cost basis of $375,000 has been paid out.
The pre-July 1986 investment in the contract and the post-June 1986 investment in the contract are adjusted for the purpose of determining the exclusion ratios in the following manner:
An exclusion ratio (which may be expressed as a fraction or as a percentage) must be determined for the contract.
The exclusion ratio of an individual whose annuity starting date (see Q 10) is after December 31, 1986, applies to payments received until the payment in which the investment in the contract is fully recovered.
The exclusion ratio for a particular contract is the ratio that the total investment in the contract (see Q 8) bears to the total expected return (see Q 9) under the contract.
The usual annuity treatment, involving exclusion ratios, results in part of the "basic" $5,000 benefit being taxable, as a result of interest earned.
The table below presents exclusion ratios for various interest rates and payout periods.
FIXED-PERIOD ANNUITY EXCLUSION RATIOS Years in Payout Period Interest 10 20 30 40 1% 94.7% 90.2% 86.0% 82.1% 2 89.8 81.8 74.7 68.4 3 85.3 74.4 65.3 57.8 Years in Payout Period Interest 10 20 30 40 4 81.1 68.0 57.6 49.5 5 77.2 62.3 51.2 42.9 6 73.6 57.3 45.9 37.6 7 70.2 53.0 41.4 33.3 8 67.1 49.1 37.5 29.8 9 64.2 45.6 34.2 26.9 10 61.4 42.6 31.4 24.4 The standard deduction and personal exemptions together with the exclusion ratio combine to allow quite large annual annuity payments without any tax, assuming the annuity is the only source of taxable income.
Once again, based on values in the exclusion ratio table, the annuitant would treat 53% of any payment in excess of $52,872 as a tax-free recovery of investment.
This liquidity comes at a price, however, in that exclusion ratios do not apply to such partial withdrawals under the federal income tax code.
In certain trading annuities, when income is to be turned on, there is a SPIA-like withdrawal benefit that offers an exclusion ratio. This means that for a person who decides to begin income after 10 years--let's say at age 65 or so--the income is going to be largely untaxed for a number of years; perhaps 70 percent or more won't be taxed over a fairly long period of time.
At some point, of course, the taxman must be paid; when the exclusion ratio has captured all of the cost basis, it ends and all remaining income is taxed.