Tax-free portion of annuity payments
Quick Definition: The exclusion ratio determines what percentage of each non-qualified annuity payment is tax-free return of principal versus taxable gain. This only applies to annuitized payments from non-qualified annuities, not withdrawals or qualified annuities.
Formula: Original Premium ÷ Expected Total Payments = Exclusion Ratio
Example:
Original premium: $200,000
Life expectancy payments: $400,000
Exclusion ratio: $200K ÷ $400K = 50%
Result: 50% of each payment is tax-free, 50% is taxable
If monthly payment is $2,000:
→ $1,000 tax-free (principal return)
→ $1,000 taxable (gain)
Applies to:
Does NOT apply to:
Once you've recovered your full principal through payments, all subsequent payments are 100% taxable.
Example: Live beyond life expectancy tables by 10 years—those extra years' payments are fully taxable since you've already recovered your $200K principal.
Exclusion ratio provides favorable tax treatment for non-qualified annuitized payments by spreading principal recovery evenly across payments. This makes part of each payment tax-free. Only applies after annuitization of non-qualified funds.