Exclusion Ratio

The exclusion ratio for an annuity determines:

1. A.The taxable vs tax-free (return of principal) portion of paymentsCorrect - it allocates each payment for tax.
2. B.The death benefitThis ratio governs the taxation of payments during the payout phase, not what is paid at death. An annuity's death benefit is set by the contract terms, not by a tax formula.
3. C.The surrender chargeSurrender charges are a contractual recovery of sales costs when the owner withdraws early. They come out of the product's fee schedule, not from any calculation of what portion of a payment is taxable.
4. D.The commissionCommission is compensation paid to the producer out of the insurer's own economics. It has no bearing on how an annuitant's payment is divided between taxable and untaxed portions.

Why: The exclusion ratio splits each annuity payment into a taxable earnings portion and a tax-free return of principal.

Marisol retires and uses her entire 401(k) balance, funded exclusively with pre-tax salary deferrals and employer contributions, to buy an annuity that will pay her a monthly income for life. How much of each monthly payment is taxable?

1. A.None of it, because qualified plan distributions taken as lifetime income are tax exemptQualified plan distributions are taxable. Deferral ends when the money comes out.
2. B.All of it, because she has no investment in the contract and therefore nothing to excludeCorrect. Zero basis means no exclusion ratio; the entire payment is ordinary income.
3. C.Only the portion exceeding her original account balance at retirementNo such rule exists. The account balance is not basis when the contributions were never taxed.
4. D.Only the portion attributable to earnings, with the rest excluded as a return of principalThere is no after-tax principal here. Every dollar in the plan was contributed pre-tax.

Why: The exclusion ratio exists to return an annuitant own AFTER-TAX money tax free. Marisol never paid tax on a dollar that went into this plan, so her investment in the contract is zero and there is nothing to exclude. One hundred percent of every payment is taxable as ordinary income. This is the clean line between a QUALIFIED annuity, where the whole payment is normally taxable, and a NONQUALIFIED annuity bought with after-tax dollars, where the exclusion ratio shelters part of each payment.

An annuity with a 90,000 investment and a 180,000 expected return has an exclusion ratio of:

1. A.50%Correct - investment / expected return.
2. B.100%Would mean every dollar paid out is a return of the owner's own money and none of it is ever taxed. That happens only when the expected return equals the amount invested, which it does not here.
3. C.66.7%Comes from pairing the wrong two numbers. The ratio is the investment in the contract divided by the expected return, so 90,000 over 180,000.
4. D.33%Uses neither figure the stem supplies. Basis makes up half of what the contract is expected to pay, so half of every payment is excluded.

Why: Exclusion ratio = 90,000 / 180,000 = 50%.

An annuity with a 150,000 investment and a 300,000 expected return has an exclusion ratio of:

1. A.66.7%Comes from pairing figures the stem does not give. The numerator is the investment in the contract, which is 150,000.
2. B.50%Correct - investment / expected return.
3. C.25%Halves the correct ratio, as if the denominator were twice the expected return. The expected return in the stem is 300,000.
4. D.100%Would shield every dollar of every payment from tax. That only holds when the expected return matches the amount invested, and here the contract is expected to return twice what went in.

Why: 150,000 / 300,000 = 50%.