When an annuitant annuitizes an annuity with a cost basis, the portion of the income benefit payment that is taxed is determined by the:

• A. Investment At Risk
• B. Cost Basis Ratio
• C. Exclusion Ratio
• D. Tax Rate

Answer: (C)

When an annuity is annuitized, part of each payment represents a return of the money you already invested (cost basis) and isn’t taxed, while the rest represents earnings and is taxed as ordinary income. The amount that can be excluded from tax is set by the exclusion ratio. This ratio compares your cost basis to the expected total return of the contract, so you can determine what portion of each payment is a tax-free return of principal.

For example, if your cost basis is $20,000 and the expected total return from the contract is $100,000, the exclusion ratio is 20,000/100,000 = 20%. Therefore 20% of each payment is tax-free, and the remaining 80% is taxed as ordinary income.

Investment At Risk and Tax Rate don’t determine the tax-free portion of each payment. The cost basis ratio term isn’t the standard designation used here; the official concept is the exclusion ratio.