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 a fraction used to determine the amount of annual annuity income exempt from federal income taxation. The exclusion ratio is the total contribution (contract investment) in the annuity divided by the expected ratio or return (life expectancy).
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%. The Florida study manual explains the theory thusly:
"If the investment experience is favorable, the application of a constant exclusion ratio to a substantially increased annuity would increase the tax-free portion of each payment. The Treasury Department has issued rules that prevent the exclusion ratio from operating to produce such an effect. The investment in the contract and the expected return are deemed to be equal and thus the exclusion ratio for variable annuities is 100%. The amount that can be received free of income tax in a taxable year is the portion of the investment in the contract that is allocated to that year. This is determined by dividing the investment by the number of years the annuitant is expected to live. For example, if the annuitant purchased a variable life annuity contract for $15,000 at age 65, the annual tax-free portion is $1,000 ($15,000 divided by 15 years of life expectancy). The excess received each year is taxable income."
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.
1 |
Section 7.4 ReviewWhich of the following applies to annuity income tax treatments and benefits? |
2 |
The excise penalty tax is imposed before the annuitant reaches the age of: |
3 |
A structured settlement occurs when an annuity is used to distribute funds from the settlement of lawsuits or the winnings of lotteries and other contests. |
4 |
The exclusion ratio is considered ______% in variable annuities. |
