What Is an Exclusion Ratio?

Alex Newth
Alex Newth
Man climbing a rope
Man climbing a rope

Annuity investors often have to pay taxes on their returns, but a portion of the return that is not taxed is known as the exclusion ratio. The reason this exclusion ratio is not taxed is because, even though it is a return, it is thought simply to replenish the money investors used to start the annuity. To figure out the ratio’s percentage, the amount paid for the annuity and the anticipated return are divided. Most annuity investors will completely replenish their investment costs, at which point the ratio becomes invalid.

When someone makes a return on his investment, the return is taxed the same as a worker’s income. With an exclusion ratio, only a small portion — not the entire return — is taxed. This ratio mostly affects annuity-based investments, but there are other investment vehicles that also may be affected by this ratio. Taxing the entire return would be like taxing everything a regular worker makes; it could lead to low returns and would make investing even riskier. While all the money an investor makes on this investment is technically considered a return, the exclusion ratio allows an investor to make up his losses, because the part that is not taxed is thought to replenish the money he paid for the investment.

Two different figures are needed to find out an exclusion ratio, or the percentage on which the investor is not taxed. One number is how much the investor paid to start the annuity investment, while the second is how much his contract states should be anticipated as a return to the investment. The two are divided, and the percentage left is the portion on which he is not taxed. For example, if the exclusion ratio is 85 percent, then only the remaining 15 percent is taxable income.

As an annuity keeps paying, it is common for an investor to recoup his initial costs. When this occurs, the exclusion ratio is abolished and all the returns are considered taxable. For example, if the startup cost is $2,000 US Dollars (USD), then as soon as the investor receives that much nontaxable money in returns, anything else gained from the investment is taxed at the full amount. If the investment does not yield enough returns to cover the cost, then it is counted as a loss and the investor will not recover his initial investment.

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