Exclusion ratio
Exclusion ratio is determined by dividing the investment included in the contract by the return that is expected from the contract as of commencement date of the annuity, and rounding to the tenth. Once calculated, the exclusion ratio applies to each pension payment given under the contract. The procedure processes up to the time when the total investment has been recovered tax-free (T. M. Myres, D. D. DeScherer 2008, P. 85). The exclusion ratio generally is not redetermined, unless a new type of annuity becomes salaried (W. D. Mitchell 2008, P. 116). After determining the ratio it remains constant, any additional payments are to be fully taxable (O. R. Whittington, P. R. Delaney 2011, Module 35).
The formula to calculate exclusion ratio (T. M. Myres, D. D. DeScherer 2008P. 85):
where:
- ER - exclusion ratio
- I - investment in a contract
- R - expected return
In case there was no investment mentioned in the contract, all payments are taxable in full (T. M. Myres, D. D. DeScherer 2008, P. 85). Exclusion ratio determines taxable and non taxable components of payments taxable under Code Section 72 (W. D. Mitchell 2008, P. 115). The annuity exclusion ratio is used to determine the amount of each payment that is being excluded from income. It is the cost of the contract divided by the number of payments expected (K. E. Murphy, M. Higgins, T. K. Flesher, R. K. Skalberg 2017, P. 3-11).
Determining exclusion ratio
Before determining exclusion ratio, following steps must be performed (W. D. Mitchell 2008, P. 115):
- Determining whether the amount is paid after the annuity starting date (the date of the first day of the first period for which an amount is payable).
- Determining whether the amount is received as an annuity. It is received as an annuity given that it is payable at regular intervals over more than one-year period.
Examples of Exclusion ratio
- For example, an exclusion ratio of 60% would mean that 60% of each pension payment is excluded from taxation and the remaining 40% is taxable income.
- Suppose an individual purchased an annuity for $50,000 with a return of $500 a month. The exclusion ratio would be calculated by dividing $50,000 by $500, which results in a ratio of 0.1 (10%). This means that 10% of the $500 monthly payment is excluded from taxation, while the remaining 90% is taxable income.
- Another example is an annuity purchased for $100,000 with a return of $4,000 a month. The exclusion ratio would be calculated by dividing $100,000 by $4,000, which results in a ratio of 0.025 (2.5%). This means that 2.5% of the $4,000 monthly payment is excluded from taxation, while the remaining 97.5% is taxable income.
Advantages of Exclusion ratio
The exclusion ratio is advantageous for annuity holders as it allows them to recover their investment tax free, as well as provides a level of tax deferment. The advantages of the exclusion ratio include:
- The exclusion ratio provides an annuity holder with tax deferment, as payments are only taxed when the total investment has been recovered.
- The exclusion ratio also allows annuity holders to recover their investment tax free, as opposed to other investment strategies, such as stocks and bonds, which are taxed upon sale.
- The exclusion ratio also creates a more predictable tax situation, as the ratio remains constant throughout the annuity period. This allows annuity holders to better plan the amount of taxes they will owe each year.
- The exclusion ratio also provides an annuity holder with a more reliable return on investment, as the taxes are deferred until the total investment is recovered, meaning the annuity holder can count on receiving the full amount of their return.
Limitations of Exclusion ratio
The exclusion ratio is a useful tool for determining the taxable amount of pension payments, but it is not without its limitations. These limitations include:
- The exclusion ratio does not take into account any changes in the investment value, meaning that the ratio will remain the same even if the value of the investment goes up or down.
- The exclusion ratio does not take into account any changes in tax laws or regulations that could affect the taxable amount of the pension payments.
- The exclusion ratio does not consider any cost of living adjustments that may be included in the pension payments.
- The exclusion ratio does not account for any other income sources that may affect the taxable amount of the pension payments.
- The exclusion ratio only applies to annuity contracts, and not to other types of pension or retirement plans.
In addition to the exclusion ratio, there are other approaches to determine how much of a pension payment is taxable. These include:
- The Simplified Method: Under the Simplified Method, a taxpayer can elect to take a standard deduction of up to 50% of the annual pension payments, which are then excluded from taxable income.
- The Maximum Exclusion Amount Method: Under this method, a taxpayer may elect to exclude up to the lesser of their annual pension payments or the maximum annual exclusion amount from taxable income.
- The Recoupment Method: Under the Recoupment Method, the taxpayer may elect to exclude from taxable income the amount of their annual pension payments up to the amount that would have been taxable if the pension payments were made over the life of the taxpayer.
In summary, there are several approaches to determine how much of a pension payment is taxable, each of which involves different calculations and considerations. The exclusion ratio is one of the most common methods used, but there are other approaches as well.
| Exclusion ratio — recommended articles |
| Unearned Premium — Original issue discount — Treasury Stock Method — Yield maintenance — Nominal rate of return — Salvage value — Annualized rate — Effective rent — Non capital loss |
References
- Hallman G. V., Rosenbloom J. S. (2014)., Private Wealth Management: The Complete Reference for the Personal Financial Planner, Ninth Edition, The Wharton School
- Mitchell W. D. (2008)., Estate and Retirement Planning Answer Book 2009 Edition, CHH, Chicago
- Murphy K. E., Higgins M., Flesher T. K., Skalberg R. K. (2017)., Concepts in Federal Taxation 2017 Edition, Cengage Learning, Boston
- Myres T. M., DeScherer D. D. (2008)., Individual Tax Answer Book 2009 Edition, CCH, Chicago
- Ray T. J. (2007)., Charitable Gift Planning, A Practical Guide for the Estate Planner Second Edition
- Schnepper J. A. (2017)., How to Pay Zero Taxes, 2018: Your Guide to Every Tax Break the IRS Allows, Mc Graw Hill Education
- Whittington O. R., Delaney P. R. (2011)., CPA Exam Review 38th Edition Volume 1: Outlines and Study Guides,,, Wiley, New Jersey
Author: Karolina Liskiewicz
