Exclusion Ratio

What Is the Exclusion Ratio?

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 return 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.

Key Takeaways

  • The exclusion ratio refers to the percentage of an investor's return that isn't subject to taxes.
  • Exclusion ratios are often used in annuities.
  • Exclusion ratios can be effective performance measures for investments other than securities requiring tax strategies or enhanced risk management techniques.

How the Exclusion Ratio Works

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 as follows:

Investment in a Contract / Expected Return.

Example of an Exclusion Ratio

Let's say a 60-year-old, Alex, purchases a $50,000 immediate annuity. The insurance company assumes Alex has a 20-year life expectancy and promises to pay Alex $284/month. Thus, Alex's initial investment of $50,000 is expected to grow to $68,160. However, the insurance company is required to spread Alex's $50,000 over 20 years, which equals around $208/month.

The IRS does not tax the first $208 of Alex's monthly payment from the insurance company because it rightly considers this a tax-free return of their principal. Depending on other factors such as Alex's overall income and their retirement status, the payment above $208 will be taxed.

Special Considerations

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.

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