The taxable portion of each annuity payment is calculated using which method?

• A. Effective interest rate method
• B. Exclusion ratio method
• C. Straight-line depreciation method
• D. Present value factor method

Answer: (B)

Verified step by step guidance

1. Understand the concept of an annuity: An annuity is a series of payments made at regular intervals, often used in retirement planning. Some portion of each payment may be taxable, depending on the method used to calculate it.
2. Learn about the exclusion ratio method: This method is used to determine the taxable portion of each annuity payment. It calculates the ratio of the investment in the contract (the amount paid for the annuity) to the expected total return (the sum of all payments expected to be received).
3. Apply the exclusion ratio formula: The exclusion ratio is calculated as follows: $\frac{\mathrm{Investment in Contract}}{\mathrm{Expected Total Return}}$. The result is the portion of each payment that is considered non-taxable, as it represents a return of the original investment.
4. Determine the taxable portion: Subtract the non-taxable portion (calculated using the exclusion ratio) from the total annuity payment to find the taxable portion of each payment.
5. Review the other methods mentioned: The effective interest rate method, straight-line depreciation method, and present value factor method are not used for calculating the taxable portion of annuity payments. These methods are applied in different contexts, such as interest calculations, asset depreciation, or valuation of future cash flows.