Income Taxes on Retirement Plans, Pensions and Annuities

Pensions, annuities, qualified plans, unqualified plans, periodic payments, lump sum distributions, rollovers – all have their own special treatment for tax purposes. Find out which rules apply in your case.

There are 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 an “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, regarding the period over which you get the benefits, 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.
  • 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 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

To be considered a “qualified plan” for tax purposes, the plan must meet satisfied 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 policy 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

It is a stock bonus, pension, or profit-sharing plan set up by an employer by IRS requirements to receive unique 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 particular 10-year tax option on lump-sum distributions if the participant qualifies.

Qualified Annuity Plan

It is a retirement annuity that an employer purchases for an employee, that meets specific IRS requirements.

Tax-Sheltered Annuity Plan

It is a type of retirement plan that is usually for employees of public schools and certain tax-exempt organisations.  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 organisation.  You don’t need to pay the tax on employee compensation that is deferred under the plan or on earnings from the plan investments.  Pay the tax when you make withdrawals or distributions from the plan.

Qualified Plans for Self-Employed Persons

People often refer to these plans 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 agreement.  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 amounts you receive from one plan may be wholly payable, 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 value in the contract if:

  • You did not make any payments, or are not considered to have made any payments toward the deal,
  • 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.  It 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 value.  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 will use the Simplified Method if you are receiving benefits under a qualified plan, including a qualified employee plan, an eligible employee annuity, or a tax-sheltered annuity plan or contract.  We cannot use This method for unqualified plans.

We use the General Method for unqualified plans, and generally cannot be used for qualified plans.

The method you use determines when you first start receiving annuity payments, and you continue to use this method 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.  It is the first day of the first period for which you receive a benefit payment or the time 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 starting date is January 1st since this is the first period for which you make the annuity payments, even though you do not 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 General Rule.
  • Annuity starting date on July 1, 1986, or before: You would use 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 starting 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, an eligible 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 five years of guaranteed payments.  Otherwise, you must use 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 you have retrieved the total cost 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 you 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 you include 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 value does not contain any costs you paid for health and accident benefits.

You must reduce your cost by refunds of premiums, rebates, dividends, loans that you did not repay, or any other tax-free amounts you’re 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 General Rule, whichever is applicable, you are in effect prorating your cost over the period you receive payments, and any excess of each amount you receive, over your prorated value, 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 General Rule depends on whether the plan is a qualified or unqualified plan.  And it will also depend on when you started receiving payments.

You could use the Simplified Method if you started received payments after November 18, 1996, under a qualified plan.  After that date, General Rule is used only for nonqualified plans.  If you began receiving payments between July 1, 1986, and November 18, 1996, you could use either 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, you can take the expected number of monthly payments from a table, based on the annuitant’s age on the annuity starting date.

How To Use the Simplified Method

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.  To complete the spreadsheet, 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 that you take from the table that is on 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.  You can take the number of expected payments 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 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 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 General Rule, the tax-free and taxable portions of payments you receive are by the ratio of your cost in the contract to the total expected return, which is determined based on actuarial tables.

Instructions for using General Rule and the actuarial tables you need to determine the tax-free and taxable portions of your payments get 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 primary annuitant had been using 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 a 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 particular type of plan, all at once.  On Form 1099-R, you should check the “Total distribution” box in 2b.  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 would be optional methods of calculating the tax on lump-sum distributions from a qualified employee plan or a qualified employee annuity, if the participant were born before January 2, 1936.

1.      The part of the distribution that corresponds to participation before 1974, they consider it as a capital gain subject to a 20% tax.  The role of the distribution of involvement 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 role of the involvement from 1974 on.

3.      You can use the 10-year option to determine the charge 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 will complete Part II of Form 4972.  If you want the 10-year tax option, you will complete Part III.

The 10-year tax option is a unique 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 ten years.  The ten years refer to the nature of the count 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 your IRA.  No tax would be currently due on the amount you roll over.  The not rolled over part of the distribution that they would consider it 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 you make the distribution 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 withheld money to replace the 20% tax.  Otherwise, 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 an allotment.

Disability Pensions

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

You might be entitled to a tax credit if you were permanently and 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 submit 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 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..  You can report the total amount of the payments and distributions you received during the year in box 1, and you can show the amount taxable as ordinary income 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, (you should check the box) you will have to use 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.

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