There are basically three groups of retirement plans, pensions, and annuities for U.S. federal income tax purposes:

• Pensions or annuities you receive from a qualified pension plan that your employer maintains to provide benefits to employees
• Benefits you receive when you retire on disability
• A commercial annuity plan that you purchase yourself.

Pensions and Annuities

Pensions and annuities are different types of arrangements, but have similar tax treatment.

• For tax purposes, a pension is a “a series of definitely determinable payments made to you after you retire from work”.  So pensions are generally associated with benefits you receive from an employer-provided plan based on your years of service and your compensation while you were working.
• An annuity is “a series of payments under a contract made at regular intervals over a period of more than one full year”.  Payments can be fixed or variable, and you can take out an annuity contract on your own, or with the help of your employer.

Types of Pensions and Annuities

There are different types of pensions and annuities, in terms of the period over which benefits are paid, who receives the benefits, and whether the benefits are fixed or variable.

• Fixed-period annuities:  You receive fixed amounts at regular intervals over a specified period of time.
• Annuities for a single life:  You, as the beneficiary, receive fixed amounts at regular intervals for life. The payments cease upon your death.
• Joint and survivor annuities:  You, as the first annuitant or beneficiary, receive fixed amounts at regular intervals for life.  After your death, the second annuitant (your spouse, dependent, or other designated beneficiary) then receives benefits for the rest of his or her life.  The amounts paid to the second annuitant may or may not be the same as for you as the first annuitant.
• Variable annuities:  You receive payments that may vary in amount, either over a specified period of time, or for life.  The amount of the annuity payments may depend on the profits earned by the pension or annuity fund or a mutual fund, and  cost-of-living indexes.

Employee Pensions and Annuities

In order to be considered a “qualified plan” for tax purposes, the plan must meet certain Internal Revenue Service (IRS) requirements.  Three different types of plans that generally meet this conditions are qualified employee plans, qualified employee annuities, and tax-sheltered annuity plans.  Whether a plan is qualified or unqualified will determine which method is used to determine the tax-free and taxable parts of the payments you receive from the plan.

Qualified Employee Plan

This is a stock bonus, pension, or profit-sharing plan set up by an employer in accordance with IRS requirements in order to receive special tax benefits.  Contributions made to the plan are generally tax-deductible expenses for the employer and are tax-deferred for the employees.  The proceeds, or benefit payments from these plans can also qualify for capital gain treatment or a special 10-year tax option on lump sum distributions, if the participant qualifies.

Qualified Annuity Plan

This is a retirement annuity that an employer purchases for an employee, that meets certain IRS requirements.

Tax-Sheltered Annuity Plan

This is a type of retirement plan that is usually provided to employees of public schools and certain tax-exempt organizations.  Benefits are generally provided by purchasing annuities for the employees.  These plans are also known as 403(b) plans, or tax-deferred annuity plans.

Section 457 Plans

These are deferred compensation plans for employees of a state or local government or a tax-exempt organization.  Tax is not paid on employee compensation that is deferred under the plan or on earnings from the plan investments.  Tax is paid when withdrawals or distributions are made from the plan.

Qualified Plans for Self-Employed Persons

These plans are often referred to as H.R. 10 or Keogh plans.  They can be set up by sole proprietorships, partnerships, and corporations.  They can cover the self-employed individual as well as employees.

Taxation of Periodic Payments

The periodic payments you receive under a pension plan or annuity contract may be fully taxable or partially taxable, depending on your cost in the plan or contract.  And, if you have more than one type of plan, such as a pension plan and a profit-sharing plan, you may need to make separate calculations to determine the tax-free and taxable portions of the payments you receive under each plan.  For example, the payments you receive from one plan may be fully taxable, while payments from another plan may be only partially taxable.

Fully Taxable Payments

Generally, if you receive pension benefits from a plan your employer maintained, and you did not contribute to the cost of the pension plan, your benefits are fully taxable.  You have no cost in the contract if:

• You did not make any payments, or are not considered to have made any payments toward the contract,
• Your employer did not withhold any contributions from your pay, or
• You got back all your contributions tax-free in prior years.

If you made voluntary employee contributions to the plan and you were able to deduct these contributions from your taxable income when you made them, any distributions you receive based on these voluntary contributions will be fully taxable when you receive them.  This includes any earnings on those contributions.

Partially Taxable Payments

If you paid part of the cost of the plan, you do not have to pay income tax on the part of your pension or annuity that represents a return of your cost.  Any amount of the benefit that exceeds your cost would be taxable.

There are two methods for determining the tax-free and the taxable parts of your annuity payments.  These are the:

• Simplified Method, and
• General Rule

You would use the Simplified Method if you are receiving benefits under a qualified plan, including a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan or contract.  This method cannot be used for unqualified plans.

The General Method is used for unqualified plans, and generally cannot be used for qualified plans.

The method you use is determined when you first start receiving annuity payments and this method continues to be used every year that you are recovering your cost.

Once you determine the amount of each payment that represents a return of your cost, this amount stays the same throughout the period you receive benefits, even if the amount of your benefit payment changes, such as under a variable annuity contract.

Starting Date of Annuity Plan

Your cost in a pension or annuity plan is referred to as your net investment in the contract as of the annuity starting date.  This is the first day of the first period for which you receive a benefit payment, or the date on which the obligations under the plan become fixed, whichever date is later.  For example, once you have completed all the payments you are required to make to an annuity contract, and the plan benefits are scheduled to begin on February 1st of the year, for the period beginning January 1st, your annuity stating date is January 1st, since this is the first period for which annuity payments are made, even though you do no actually receive the benefits until February 1st.  For tax purposes, you would need to determine your cost as of January 1st in this example.

Your annuity starting date will also determine which method you must use, as follows:

• Annuity starting date after July 1, 1986, but before November 19, 1996 under a qualified plan:  You could have chosen to use either the Simplified Method or the General Rule.
• Annuity starting date on July 1, 1986 or before: You use the General Rule, unless you chose to use the Three-Year Rule.  That rule was repealed for annuities starting after July 1, 1986, so if you used the Three-Year Rule, your annuity payments would now be fully taxable.
• Annuity stating date on November 19, 1996 or later:  You must use the Simplified Method if you meet both the following conditions:
• You receive your payments from a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan (403(b) plan), and
• On the annuity starting date, you are under 75 years of age, or you are entitled to less than 5 years of guaranteed payments.  Otherwise, you must use the General Rule.

Exclusion from Income

In these cases, the amount you can exclude from income is limited to your cost in the plan or contract.  Once you have recovered your total cost, the payments you receive after that are fully taxable.  If the total cost has not been recovered at the time of your death, or the death of the beneficiary receiving the annuity (the last annuitant), the unrecovered cost can be taken as a miscellaneous itemized deduction on Schedule A.  In this case, the deduction is not subject to the 2% of adjusted gross income limit.

But if your annuity starting date is before 1987, you can continue taking the monthly exclusion for the part of the payment that was calculated as your cost for as long as you receive the annuity.  And if it is a joint and survivor annuity, your survivor can continue to exclude the same monthly amount.  In this case, the total amount excluded can be more than your cost in the annuity.

Your Cost or Investment in the Contract

Your cost is the total of all the premiums, contributions, or other amounts you paid.  It also includes any amounts your employer paid to the plan that were included in your taxable income.  Your cost does not include amounts that were withheld from your pay and contributed to the pension or annuity plan on a tax-deferred basis.  And, your cost does not include any amounts you paid for health and accident benefits.

You must reduce your cost by refunds of premiums, rebates, dividends, loans that were not repaid, or any other tax-free amounts your received under the contract or plan up until the later of your annuity starting date, or the date on which you received your first benefit payment.

In general, you recover your cost over the period for which you are entitled to receive payments.  Using either the Simplified Method or the General Rule, whichever is applicable, you are in effect prorating your cost over the period you receive payments, and any excess of each payment you receive, over your prorated cost, is taxable income. 

Your employer or plan administrator should give you a Form 1099-R, that shows your cost in box 9b.

Simplified Method and General Rule

Whether you use the Simplified Method or the General Rule depends on whether the plan is a qualified or unqualified plan.  And it will also depend on when you started receiving payments.

The Simplified Method is used if you started received payments after November 18, 1996 under a qualified plan.  After that date the General Rule is used only for nonqualified plans.  If you started receiving payments between July 1, 1986 and November 18, 1996, you could use either the General Rule or the Simplified Method.

Simplified Method

Under this method, you take your total cost or investment in the contract, as defined above, and divide by the total number of anticipated monthly payments to determine how much of each payment is a recovery of cost, and therefore tax-free.  For an annuity payable for life, the expected number of monthly payments is taken from a table, based on the annuitant’s age on the annuity starting date.

How To Use the Simplified Method

In order to calculate the tax-free and taxable portions of your annuity payments under the Simplified Method, you can use the worksheet in the back of IRS Publication 575, Pension and Annuity Income.  In order to complete the worksheet, you will need to know your total cost in the contract, and the total number of expected monthly payments.

Number of Expected Payments

• Fixed-period annuity:  The number of payments does not depend on anyone’s life expectancy, and is the total monthly payments for the contractual period.
• Single-life annuity:  The annuity is payable for your life, and the number of expected payments is taken from the table that is presented with the worksheet, based on your age at the annuity starting date.
• Multiple-lives annuity:  The annuity is payable for the lives of more than one person.  The number of expected payments is taken from Table 2 of the worksheet, based on the combined ages of the annuitants as of the annuity starting date.
• If the annuity is payable to you and to more than one survivor annuitant, you combine your age and the age of the youngest survivor annuitant.
• If there is no primary annuitant and the annuity is payable to you and others as survivor annuitants, you combine the ages of the oldest and youngest annuitants.

General Rule

You must use the General Rule if you receive pension or annuity payments from a nonqualified plan, including a private annuity, an annuity you purchased commercially, or an employer plan that does not qualify under the tests for the Simplified Method.

Under the General Rule, the tax-free and taxable portions of payments you receive are based on the ratio of your cost in the contract to the total expected return, which is determined based on actuarial tables.

Instructions for using the General Rule and the actuarial tables you need to determine the tax-free and taxable portions of your payments are included in IRS Publication 939, General Rule for Pensions and Annuities.

Survivors

If you receive payments as a survivor annuitant, when the first annuitant had reported the annuity under the Three-Year Rule, you include the total amount of the payment in your taxable income.  If the first annuitant had been using the General Rule, you would continue to apply the same exclusion percentage to the payments you receive, and the resulting tax-free portion on that amount of a payment will then remain fixed.  If there are subsequently any increases in the payments you receive as survivor, the additional amount would be fully taxable.

If the first annuitant used the Simplified Method to determine the tax-free and taxable portions of the payment, you as the survivor annuitant continue to use the same tax-free amount for the payments you receive.

Lump Sum Distributions

A lump sum distribution is a distribution of the entire balance in a certain type of plan, all at once.  On Form 1099-R, the "Total distribution" box in 2b should be checked.  A distribution of the entire balance from an unqualified account, such as a commercial annuity you purchase yourself, or a Section 457 deferred compensation plan, does not qualify for the special tax treatment of lump sum distributions.

There are optional methods of calculating the tax on lump sum distributions from a qualified employee plan or a qualified employee annuity, if the participant was born before January 2, 1936.

1.      The part of the distribution that corresponds to participation before 1974 can be treated as a capital gain subject to a 20% tax.  The part of the distribution for participation from 1974 on, would be taxed as ordinary income.

2.      You can report the part of the distribution for participation before 1974 as capital gain and use the 10-year tax option to figure the tax on the part for participation from 1974 on.

3.      You can use the 10-year option to determine the tax on the entire amount of the distribution.

4.      You can roll over part or all of the distribution.  You would not be subject to tax this year on the part you roll over.

5.      Or you can report the entire distribution as ordinary income.

To use these optional methods, you will need to file Form 4972, Tax on Lump-Sum Distributions.  If you choose the capital gain treatment, you would complete Part II of Form 4972.  If you choose the 10-year tax option, you would complete Part III.

The 10-year tax option is a special formula used to calculate the tax on the ordinary income portion of the lump sum distribution.  The tax resulting from this calculation is paid in the current year and not over 10 years.  The 10 years refer to the nature of the calculation and not to the payment of the tax.

Rollovers

You can roll over all or part of the distribution you receive from a qualified employee plan or a qualified employee annuity into another qualified plan or into your IRA.  No tax would be currently due on the amount you roll over.  The part of the distribution that is not rolled over would be treated as ordinary income.

A rollover generally needs to be made within 60 days from the date you receive the distribution.  You can do a direct rollover from one qualified plan to another, or to your IRA.  Or you can receive the distribution and then roll it over to a qualified plan or IRA within 60 days.  In this case, the administrator of the plan from which the distribution is made will withhold a 20% income tax from the amount distributed.  If you decide to roll over the amount of the distribution before withholding, you will have to put in money to replace the 20% tax that was withheld.  Otherwise, that 20% will be subject to tax in the current year.

If you are a surviving spouse you can roll over a distribution you receive from a qualified plan in which your deceased spouse participated.  But a beneficiary other than the participant’s spouse cannot roll over a distribution.

Disability Pensions

Disability benefits are generally taxable if they are provided by your employer.  They are reported as wages for tax purposes until you reach minimum retirement age.  Once you reach minimum retirement age, your disability benefits are reported as a pension or annuity. 

You may be entitled to a tax credit if you were permanently and totally disabled when you retired.  You can see IRS Publication 524, Credit for the Elderly or Disabled, to see if you qualify.  This credit is claimed on Schedule 3 if you file Form 1040A, or on Schedule R if you file Form 1040.

Purchased Annuity Contracts

If you buy a commercial annuity on your own, with life insurance proceeds, for example,  the annuity payments you receive are taxed as pension and annuity income from a nonqualified plan.  You would generally have to use the General Rule to determine the taxable portion of the annuity payments you receive.

How To Report

You should receive Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc..  The total amount of the payments and distributions you received during the year is reported in box 1, and the amount taxable as ordinary income is shown in box 2a.  These amounts are reported on lines 16a and 16b on Form 1040, or on lines 12a and 12b if you use Form 1040A.

If your Form 1099-R does not show the taxable amount, (the box should be checked) you will have to use the General Rule explained in IRS Publication 939 to figure the taxable part you need to enter on line 16b for Form 1040, or 12b for Form 1040A.