AD Banker Comprehensive Practice Exam

The exclusion ratio states that once the entire cost basis has been recovered from a non-qualified annuity income benefit payout, then any further payments are:

1. Taxed at the favorable annuity continuation income rates

2. Fully taxable since the excess payments must represent only earnings

3. Taxed as capital gain but only 50% of the gain is applied

4. Still tax favored for annuitants over the age of 70

The correct answer is: Fully taxable since the excess payments must represent only earnings

The concept of the exclusion ratio is crucial in understanding how non-qualified annuities are taxed. In the context of annuities, the cost basis refers to the amount of money that an individual has invested in the annuity, which typically consists of after-tax contributions. The exclusion ratio helps determine how much of each annuity payment is considered a return of the original investment (which is not taxable) versus how much is considered earnings (which is taxable). Once the entire cost basis has been recovered through distributions, any subsequent payments received from the annuity are fully taxable. This is because these further payments are considered to be pure earnings, as the initial investment has already been recouped. This means that when an individual continues to receive income from the annuity after all of their principal investment has been recovered, that income is treated as taxable income since it's derived solely from the earnings generated by the annuity. Understanding this taxation structure is essential for anyone managing a non-qualified annuity, especially when planning for retirement or considering the implications of withdrawing funds from such an investment.