The exclusion ratio is a formula used to determine how much of each annuity income payment is considered a tax-free return of your original premium (cost basis) and how much is taxable gain. It applies when you annuitize a non-qualified annuity into a stream of income payments.
How the Exclusion Ratio Works
The formula divides your original investment (cost basis) by the total expected return over the payout period. The result is the percentage of each payment that is tax-free.
Example: You invest $100,000 in a non-qualified annuity and annuitize into payments expected to total $150,000 over your lifetime. Your exclusion ratio is $100,000 / $150,000 = 66.7%. That means 66.7% of each payment is tax-free (return of premium) and 33.3% is taxable (gain).
When the Exclusion Ratio Applies
The exclusion ratio only applies to annuitized payments from non-qualified contracts. It does not apply to lump-sum withdrawals (which use LIFO taxation) or to qualified annuities (which are fully taxable).