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.