What does the exclusion ratio determine?

What does the exclusion ratio determine?

• A. The total amount of payments over time.
• B. The portion of each payment that is a tax-free return of principal.
• C. The interest rate credited per year.
• D. Whether withdrawals are subject to capital gains tax.

Answer: (B)

The exclusion ratio is used to separate an annuity payment into a tax-free return of principal and a taxable portion. When you fund an annuity with after-tax dollars, part of each payment is considered a return of the money you invested and isn’t taxed, while the rest is taxable as ordinary income. The ratio is based on your investment in the contract relative to the expected total return, so the portion equal to the investment is excluded from tax each time a payment is received. In short, it determines how much of each payment is a tax-free return of principal. It doesn’t set the total payments, the annual interest rate credited, or determine capital gains treatment for withdrawals.

The exclusion ratio is used to separate an annuity payment into a tax-free return of principal and a taxable portion. When you fund an annuity with after-tax dollars, part of each payment is considered a return of the money you invested and isn’t taxed, while the rest is taxable as ordinary income. The ratio is based on your investment in the contract relative to the expected total return, so the portion equal to the investment is excluded from tax each time a payment is received. In short, it determines how much of each payment is a tax-free return of principal. It doesn’t set the total payments, the annual interest rate credited, or determine capital gains treatment for withdrawals.