Annuity exclusion ratio is the fraction used to determine how much of each annuity payment is treated as a tax-free return of principal versus taxable earnings when a nonqualified annuity is annuitized. The ratio is generally calculated by dividing the ownerTMs investment in the contract (basis) by the expected return, which is the total amount of payments anticipated over the annuitantTMs life expectancy or the term of the payout. During the expected payout period, the same exclusion ratio is applied to each payment; once basis is fully recovered, subsequent payments become fully taxable. The exclusion ratio allows for even distribution of taxable and tax-free amounts across scheduled payments.

Advisors reference the annuity exclusion ratio when explaining the tax treatment of life-only or period-certain annuity payouts from nonqualified contracts. Clients often expect all payments to be taxable, so learning that part is a tax-free return of principal can be a positive surprise. CPAs use the exclusion ratio reported by carriers to prepare tax returns accurately, and Form 1099-R typically reflects the taxable portion of each payment. Advisors compare annuitization using the exclusion ratio to alternative strategies such as systematic withdrawals, which may follow different tax ordering rules. Understanding the annuity exclusion ratio helps advisors and clients weigh the tax and cash-flow implications of annuitization versus other distribution methods.