PSI Life Exam Practice Test

How is the taxable portion of a monthly income benefit from a nonqualified annuity during the annuity phase calculated?

1. Annual Exclusion Method

2. Withdrawal Amount Method

3. Exclusion Ratio

4. Net Gain Calculation

The correct answer is: Exclusion Ratio

The taxable portion of a monthly income benefit from a nonqualified annuity during the annuity phase is calculated using the exclusion ratio. This method is specifically designed for determining how much of each annuity payment is subject to taxation and how much is considered a return of the investment made in the annuity. The exclusion ratio is based on the idea that a portion of each payment is a return of the original investment (the cost basis) and, therefore, not taxable, while the remaining portion, representing earnings, is taxable. This ratio is determined by dividing the total investment in the annuity by the expected total payout over the life of the annuity. As payments are received, the calculated portion of the payment representing the original investment is excluded from taxes. Other options, while they may seem relevant, do not apply directly to the tax calculation of nonqualified annuities. The annual exclusion method typically relates to gift tax considerations, the withdrawal amount method doesn’t align with how annuity income is taxed, and net gain calculation approaches do not provide the necessary breakdown for annuity benefits received in this context. Thus, using the exclusion ratio ensures that the taxation process is accurately handled during the annuity payout phase.