The exclusion ratio is the tax calculation used to separate an annuity payout into a non-taxable return of principal and a taxable earnings portion. For non qualified immediate or deferred income annuities, the insurer determines the proportion of each payment that is excluded from income until the investment in the contract is fully recovered; thereafter, payments are fully taxable. The ratio depends on cost basis, expected return, and contract terms. It ensures annuity owners are taxed only on gain, not the original after-tax premium used to purchase the contract.

Advisors explain to annuity clients that each payout includes a return of principal and taxable gain determined by the exclusion ratio. They use insurer schedules to project the non-taxable portion and plan withholding. When clients outlive their life expectancy, payments become fully taxable. Understanding the ratio helps align annuity income with after-tax retirement budgets.