What is Exclusion Ratio?
The Exclusion Ratio is a calculation used in the context of annuities to determine what portion of each annuity payment is considered a return of the original investment (non-taxable) and what portion is considered taxable income. It’s an essential concept for understanding the tax implications of annuity payments, particularly for retirement planning.
When an individual invests in an annuity, part of the payments they receive will be a return of the principal they paid into the contract, which is not subject to taxation. The remaining portion, which represents earnings or interest, is taxable. The Exclusion Ratio helps to separate these two components for tax purposes.
For example, if an individual invests $100,000 in an annuity and expects to receive $200,000 in total payments, the Exclusion Ratio helps determine how much of each payment is a non-taxable return of the original investment. If the ratio is 50%, then half of each payment is non-taxable, while the other half is taxable.
Understanding the Exclusion Ratio is critical for retirees or anyone using annuities for income, as it directly impacts tax liability. For fixed annuities, the Exclusion Ratio remains consistent, but for variable annuities, it may change as investment performance fluctuates, affecting the taxable amount.