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.