Annuity exclusion ratio calculation is the process of determining the percentage of each annuity payment that will be excluded from taxable income as a return of principal for a nonqualified annuity that has been annuitized. The calculation typically divides the ownerTMs investment in the contract (premium minus any prior nontaxable returns of basis) by the expected return, defined as the total amount of payments anticipated over the annuitantTMs life expectancy or the fixed payout term. The resulting fraction, the exclusion ratio, is then applied to each payment until the full basis has been recovered, after which all remaining payments are fully taxable. These calculations are usually performed by the carrier and reported for tax purposes, but advisors benefit from understanding the mechanics.

Advisors discuss annuity exclusion ratio calculations when clients are considering annuitizing nonqualified contracts and want to know how much of each payment will be taxable. They may illustrate sample calculations using simplified numbers to show how basis is spread across payments. CPAs and tax software rely on carrier-provided exclusion ratios and expected return figures to prepare returns. In some planning scenarios, advisors compare annuitization with alternative withdrawal approaches that use different tax ordering rules, such as LIFO for nonqualified deferred distributions. Understanding annuity exclusion ratio calculation helps advisors answer client questions about how much tax they will pay on annuity income and integrate those answers into broader retirement cash-flow projections.