The question was: I am trying to learn how to explain the exclusion ratio in a way my annuity clients will understand. Can you give me a simple explanation to use?
The answer is: "A client's investment in an annuity is returned in equal tax-free amounts during the payment period. Any additional amount received is taxed at ordinary income rates.
"This means that part of each payment is considered a return of capital and is therefore nontaxable and part of each payment is considered return on capital (income) and is therefore taxable at ordinary rates.
"The formula for determining the nontaxable portion of each year's payment is, according to the Internal Revenue Code Sec. 72(b)(1):
Investment in the contract
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Expected return
"This is called the 'exclusion ratio.' It is expressed as a percentage (rounded to three decimal places) and applied to each annuity payment to find the portion of the payment that is excludable from gross income [Treas. Reg ?1.72-4(a)(2)].
"For instance, assume a 70-year-old purchases an annuity. He pays (i.e., the investment in the contract is) $12,000 for the annuity. Assume his expected return is $19,200.
