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.