Definition and Example of Exclusion Ratio
The exclusion ratio represents the percentage of the amount that is not counted as gross income in a pension payment, and thus this amount is not subject to tax. The exclusion ratio is the percentage of the amount you receive from retirement that is excluded from your gross income. In some cases, taxes are only imposed on the portion that funds your retirement – whether it’s a qualified or non-qualified retirement – and how you receive the funds from it. In most cases, the exclusion ratio applies to non-qualified retirement.
How Exclusion Ratio Works
Pensions grow tax-deferred, and generally, you will pay taxes only when you receive the payments either through regular pension payments or through withdrawals. However, the IRS considers how you funded your retirement when determining how to tax you. In other words, did you already pay income tax on the invested funds, or did you deduct it on your tax return?
Qualified pensions are purchased through qualified retirement plans like a 401(k) plan and are funded with pre-tax money. As a result, full pension payments are treated as ordinary income subject to taxation. Non-qualified pensions are funded with after-tax money – the IRS will only tax the growth portion of your pension.
If you do not convert your pension into regular payments but are withdrawing funds, the withdrawn amount is treated on a last-in-first-out (LIFO) basis. This means that the last money deposited into the pension (the gains) is withdrawn first. Only after fully withdrawing the growth portion will you receive tax-free benefits.
What It Means for Your Retirement Benefits
Section 72 of the Internal Revenue Code provides clear instructions regarding the taxation of retirement income. These instructions allow you to receive your initial investment tax-free over the distribution period while taxing the balance received.
But what if you live beyond life expectancy? The result is that you will pay higher taxes. Surpassing life expectancy means that you will fully recover your initial investment (the capital). As a result, all payments after that point will be taxed in full.
Remember, the exclusion ratio only applies to pensions funded with after-tax money. You will pay taxes on 100% of the pension payments you receive from a tax-deferred account like an IRA or 401(k). However, you will not pay taxes on any part of the pension payments you receive from a Roth account, such as a Roth 401(k) or Roth IRA (unless you make early withdrawals).
Key Takeaways
– The exclusion ratio helps determine the taxable portion of your retirement payments.
– The exclusion ratio is calculated by dividing the initial investment in the retirement contract by the expected return.
– The exclusion ratio does not apply to tax-deferred qualified retirement accounts, where all pension payments are fully taxable.
– Any payments after exceeding life expectancy are taxed as ordinary income, as the original capital has been exhausted.
Source: https://www.thebalancemoney.com/what-is-an-exclusion-ratio-5207390
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