Interest vs Principal

• Principal - not taxed
• Interest - taxed

MR. WATSON: Now, look. Part of this $10,000 represents principal (the $150,000 death benefit).

ALL: Okay.

MR. WATSON: Part of this $10,000 represents interest.

ALL: Okay.

MR. WATSON: The part that represents principal is received tax-free. The part that represents interest is taxable, at "ordinary income" rates. To find out what is taxable, we're going to find out what is not. This is called the exclusion ratio. It tells us how much of the $10,000 is excluded from taxes. If we find out what is not taxable, we know what is. We need to find out how much is excluded from taxes.

MR. WATSON: We are going to use a formula. It's a ratio. Here's the formula.

• The total amount invested divided by the total expected return.

The exclusion ratio tells us what's excluded from taxes. You take the amount invested. How much?

ALL: $150,000.

MR. WATSON: $150,000, and you divide it by the expected return, which in this case is $200,000 ($10,000 a year for 20 years). You take the amount that went in, and you divide it by the expected return. In divided by out. How much is expected to come out over her lifetime? $200,000. That would come out to 75 percent, because $150,000 divided by $200,000 is 75 percent. 75 percent of $10,000 yearly benefit would be $7500. $7500 a year would be excluded from taxes. The rest would be taxed.

MR. WATSON: What we are trying to find out is what is excluded from taxes. You have to apply a formula. Here's the formula. Once again, how much did I leave her?

WOMAN: $150,000.

MR. WATSON: We are going to divide what I left her, what went in, the $150,000-and we are going to divide it by what's expected to be paid out.

WOMAN: How did you get $200,000?

MR. WATSON: We multiplied the $10,000 a year benefit by the 20 years she is expected to keep living, which we determined from the mortality tables. All you need to know is this-the exclusion ratio. What is the exclusion ratio on a fixed annuity ? The amount invested, divided by the expected return.

MR. WATSON: This method of taxing only the interest is called the annuity rule. Under the annuity rule a fixed unchanging fraction of each payout is considered a return of principal and is so excluded from taxes.

• So, that portion representing principal is received tax free.
• he balance of each payout (representing interest) would be taxable as ordinary income.

They are letting her get the principal back tax-free, spread out over her life expectancy.

MR. WATSON: Everything that's taxed, in this course, will be taxed at "ordinary Income" rates. Not "capital gains" rates, which would be a lower rate. Always remember that!

MR. WATSON: Another example: A guy invested $100. He's expected to get back $300. How much of the $300 is excluded from taxes?

MR. WATSON: $100 was invested and he's getting $300 back.

MR. WATSON: How much is excluded from taxes? One third is excluded. It's the same principal.