7.4.1 Exclusion Ratio
The annuitant will receive equal payments when and if the owner annuitizes (applies their annuity value toward a settlement option). Unlike withdrawals, the contract owner does not pay full taxes on the payments. Annuity payments are taxable to the extent that they represent interest earned rather than capital returned. The method used to determine the taxable portion of each payment is called the exclusion ratio.
An exclusion ratio is applied to each payment received, which stipulates that a percentage of each payment is considered a return of the owner's cost basis and is, therefore, tax free. The balance, however, is taxable.
Each withdrawal will have an exclusion ratio. The exclusion ratio is the ratio of aggregate premiums paid by the annuitant bears to the expected return over the annuitants lifetime (ER = Basis / Expected Return).
The exclusion ratio in a variable annuity payout operates under a slightly different theory, thereby indicating that the exclusion ratio in a variable annuity is always considered 100%.
Remember - The exclusion ratio is considered 100% in variable annuities.
Depending upon the annuity purchased, withdrawals can be taxed in one of two ways. Prior to 8/14/1982, annuities were structured with FIFO accounting (first in, first out), which allowed the principal to remain tax free. On 8/14/1982 and thereafter, annuity taxation changed to LIFO (last in, first out), which allowed for taxation on withdrawals since interest is withdrawn first.
