South Carolina Insurance Practice Exam

How is the taxable portion of each annuity payment calculated?

1. Accrual Method

2. Exclusion Ratio

3. Taxable Income Method

4. Net Investment Method

The correct answer is: Exclusion Ratio

The taxable portion of each annuity payment is determined using the exclusion ratio. This method calculates the proportion of each payment that is considered taxable income versus the portion that is considered a return of the taxpayer's investment in the annuity. The exclusion ratio is calculated by taking the investment in the contract (the total amount the individual paid into the annuity) and dividing it by the expected return (the total amount expected to be received from the annuity over its lifetime). This ratio helps to identify the amount of each payment that can be excluded from taxable income, as it represents the return of the principal investment. The remainder of the payment is subject to income tax because it represents earnings accrued from the investment. Understanding this method is critical for individuals planning for retirement or utilizing annuities to ensure they accurately report their tax liability and understand how their investments will impact their overall taxation.