The exclusion ratio is simply the percentage of an investor's return that is not subject to taxes. The exclusion ratio is a percentage with a dollar amount equal to the payback on an initial investment. Any return above the exclusion ratio is subject to taxes, such as a capital gains tax. Most of the time, the exclusion ratio applies to non-qualified annuities.
Breaking Down Exclusion Ratio
The exclusion ratio arises mainly through different forms of non-qualified insurance annuities.
When receiving payments from an immediate annuity or annuitization, part of every payment an annuitant receives is considered to be a return of principal, which is not taxed. The remaining portion of the payment consists of interest earnings and is taxable. The exclusion ratio determines the taxable and nontaxable portions of each payment.
The exclusion ratio formula is: Investment in a Contract / Expected Return.
An exclusion ratio will expire when all of the principal in a contract has been received (assuming you reach that point in the contract). When the entire amount of principal has been exhausted, the entire annuity payment will then be taxable.
The exclusion ratio can be an effective performance measure for certain investments requiring tax strategies or enhanced risk management techniques. Many insurance products are not technically financial securities; they offer the benefit of fewer restrictions on tax, regulatory, and oversight burdens. Savvy investors can use these instruments to engineer unique income and return streams otherwise unavailable to conventional financial securities. One such technique could include using non-qualified insurance annuities in lieu of cash. In this case, the exclusion ratio can offer a contract holder insight into the length of time to recover principal—before capital gains taxes become a factor.