Taxation of Periodic Payments

This section explains how the periodic payments you receive from a pension or annuity plan are taxed. Periodic payments are amounts paid at regular intervals (such as weekly, monthly, or yearly) for a period of time greater than one year (such as for 15 years or for life). These payments are also known as amounts received as an annuity. If you receive an amount from your plan that is not a periodic payment, see Taxation of Nonperiodic Payments, later.

In general, you can recover the cost of your pension or annuity tax free over the period you are to receive the payments. The amount of each payment that is more than the part that represents your cost is taxable.

Cost (Investment in the Contract)

The first step in figuring how much of your pension or annuity is taxable is to determine your cost (investment in the contract). In general, your cost is your net investment in the contract as of the annuity starting date. To find this amount, you must first figure the total premiums, contributions, or other amounts you paid. This includes the amounts your employer contributed that were taxable when paid. (Also see Foreign employment contributions, later.) It does not include amounts you contributed for health and accident benefits (including any additional premiums paid for double indemnity or disability benefits) or deductible voluntary employee contributions.

From this total cost you must subtract the following amounts.

1. Any refunded premiums, rebates, dividends, or unrepaid loans that were not included in your income and that you received by the later of the annuity starting date or the date on which you received your first payment.
2. Any other tax-free amounts you received under the contract or plan by the later of the dates in (1).
3. If you must use the Simplified Method for your annuity payments, the tax-free part of any single-sum payment received in connection with the start of the annuity payments, regardless of when you received it. (See Simplified Method, later, for information on its required use.)
4. If you use the General Rule for your annuity payments, the value of the refund feature in your annuity contract. (See General Rule, later, for information on its use.) Your annuity contract has a refund feature if the annuity payments are for your life (or the lives of you and your survivor) and payments in the nature of a refund of the annuity's cost will be made to your beneficiary or estate if all annuitants die before a stated amount or a stated number of payments are made. For more information, see Publication 939.

The tax treatment of the items described in (1) through (3) above is discussed later under Taxation of Nonperiodic Payments.

Form 1099-R. If you began receiving periodic payments of a life annuity in 2000, the payer should show your total contributions to the plan in box 9b of your 2000 Form 1099-R.

Annuity starting date defined. The annuity starting date is either the first day of the first period for which you receive payment under the contract or the date on which the obligation under the contract becomes fixed, whichever comes later.

Example. On January 1 you completed all your payments required under an annuity contract providing for monthly payments starting on August 1 for the period beginning July 1. The annuity starting date is July 1. This is the date you use in figuring the cost of the contract and selecting the appropriate number from the table for line 3 of the Simplified Method Worksheet.

Foreign employment contributions. If you worked abroad, your cost includes amounts contributed by your employer that were not includible in your gross income. This applies to contributions that were made either:

1. Before 1963 by your employer for that work,
2. After 1962 by your employer for that work if you performed the services under a plan that existed on March 12, 1962, or
3. After December 1996 by your employer on your behalf if you performed the services of a foreign missionary (either a duly ordained, commissioned, or licensed minister of a church or a lay person).

Fully Taxable Payments

The pension or annuity payments that you receive are fully taxable if you have no cost in the contract because:

1. You did not pay anything or are not considered to have paid anything for your pension or annuity,
2. Your employer did not withhold contributions from your salary, or
3. You got back all of your contributions tax free in prior years (however, see Exclusion not limited to cost under Partly Taxable Payments, later).

Report the total amount you got on line 16b, Form 1040, or line 12b, Form 1040A. You should make no entry on line 16a, Form 1040, or line 12a, Form 1040A.

Deductible voluntary employee contributions. Distributions you receive that are based on your accumulated deductible voluntary employee contributions are generally fully taxable in the year distributed to you. Accumulated deductible voluntary employee contributions include net earnings on the contributions. If distributed as part of a lump sum, they do not qualify for the 10-year tax option or capital gain treatment.

Partly Taxable Payments

If you contributed to your pension or annuity plan, you can exclude part of each annuity payment from income as a recovery of your cost. This tax-free part of the payment is figured when your annuity starts and remains the same each year, even if the amount of the payment changes. The rest of each payment is taxable.

You figure the tax-free part of the payment using one of the following methods.

• Simplified Method. You generally must use this method if your annuity is paid under a qualified plan (a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan or contract). You cannot use this method if your annuity is paid under a nonqualified plan.
• General Rule. You must use this method if your annuity is paid under a nonqualified plan. You generally cannot use this method if your annuity is paid under a qualified plan.

You determine which method to use when you first begin receiving your annuity, and you continue using it each year that you recover part of your cost.

Qualified plan annuity starting before November 19, 1996. If your annuity is paid under a qualified plan and your annuity starting date (defined earlier under Cost (Investment in the Contract) is after July 1, 1986, and before November 19, 1996, you could have chosen to use either the Simplified Method or the General Rule. If your annuity starting date is before July 2, 1986, you use the General Rule unless your annuity qualified for the Three-Year Rule. If you used the Three-Year Rule (which was repealed for annuities starting after July 1, 1986), your annuity payments are now fully taxable.

Exclusion limit. Your annuity starting date determines the total amount of annuity payments that you can exclude from income over the years.

Exclusion limited to cost. If your annuity starting date is after 1986, the total amount of annuity income that you can exclude over the years as a recovery of the cost cannot exceed your total cost. Any unrecovered cost at your (or the last annuitant's) death is allowed as a miscellaneous itemized deduction on the final return of the decedent. This deduction is not subject to the 2%-of-adjusted-gross-income limit.

Example 1. Your annuity starting date is after 1986, and you exclude $100 a month under the Simplified Method. The total cost of your annuity is $12,000. Your exclusion ends when you have recovered your cost tax free, that is, after 10 years (120 months). Thereafter, your annuity payments are fully taxable.

Example 2. The facts are the same as in Example 1, except you die (with no surviving annuitant) after the eighth year of retirement. You have recovered tax free only $9,600 (8 x $1,200) of your cost. An itemized deduction for your unrecovered cost of $2,400 ($12,000 minus $9,600) can be taken on your final return.

Exclusion not limited to cost. If your annuity starting date is before 1987, you can continue to take your monthly exclusion for as long as you receive your annuity. If you chose a joint and survivor annuity, your survivor can continue to take the survivor's exclusion figured as of the annuity starting date. The total exclusion may be more than your cost.

Simplified Method

Under the Simplified Method, you figure the tax-free part of each annuity payment by dividing your cost by the total number of anticipated monthly payments. For an annuity that is payable for the lives of the annuitants, this number is based on the annuitants' ages on the annuity starting date and is determined from a table. For any other annuity, this number is the number of monthly annuity payments under the contract.

Who must use the Simplified Method. You must use the Simplified Method if your annuity starting date is after November 18, 1996, and you meet both of the following conditions.

1. You receive your pension or annuity payments from any of the following qualified plans.
   1. A qualified employee plan.
   2. A qualified employee annuity.
   3. A tax-sheltered annuity (TSA) plan or contract.
2. On your annuity starting date, at least one of the following conditions applies to you.
   1. You are under age 75.
   2. You are entitled to fewer than 5 years of guaranteed payments.

Guaranteed payments. Your annuity contract provides guaranteed payments if a minimum number of payments or a minimum amount (for example, the amount of your investment) is payable even if you and any survivor annuitant do not live to receive the minimum. If the minimum amount is less than the total amount of the payments you are to receive, barring death, during the first 5 years after payments begin (figured by ignoring any payment increases), you are entitled to fewer than 5 years of guaranteed payments.

Annuity starting before November 19, 1996. If your annuity starting date is after July 1, 1986, and before November 19, 1996, and you chose to use the Simplified Method, you must continue to use it each year that you recover part of your cost. You could have chosen to use the Simplified Method if your annuity is payable for your life (or the lives of you and your survivor annuitant) and you met both of the conditions listed earlier for annuities starting after November 18, 1996.

Who cannot use the Simplified Method. You cannot use the Simplified Method if you receive your pension or annuity from a nonqualified plan or otherwise do not meet the conditions described in the preceding discussion. See General Rule, later.

How to use it. Complete the worksheet in the back of this publication to figure your taxable annuity for 2000. Be sure to keep the completed worksheet; it will help you figure your taxable annuity next year.

To complete line 3 of the worksheet, you must determine the total number of expected monthly payments for your annuity. How you do this depends on whether the annuity is for a single life, multiple lives, or a fixed period. For this purpose, treat an annuity that is payable over the life of an annuitant as payable for that annuitant's life even if the annuity has a fixed period feature or also provides a temporary annuity payable to the annuitant's child under age 25.

You do not need to complete line 3 of the worksheet or make the computation on line 4 if you received annuity payments last year and used last year's worksheet to figure your taxable annuity. Instead, enter the amount from line 4 of last year's worksheet on line 4 of this year's worksheet.

Single life annuity. If your annuity is payable for your life alone, use Table 1 at the bottom of the worksheet to determine the total number of expected monthly payments. Enter on line 3 the number shown for your age on your annuity starting date. This number will differ depending on whether your annuity starting date is before November 19, 1996, or after November 18, 1996.

Multiple lives annuity. If your annuity is payable for the lives of more than one annuitant, use Table 2 at the bottom of the worksheet to determine the total number of expected monthly payments. Enter on line 3 the number shown for the annuitants' combined ages on the annuity starting date. For an annuity payable to you as the primary annuitant and to more than one survivor annuitant, combine your age and the age of the youngest survivor annuitant. For an annuity that has no primary annuitant and is payable to you and others as survivor annuitants, combine the ages of the oldest and youngest annuitants. Do not treat as a survivor annuitant anyone whose entitlement to payments depends on an event other than the primary annuitant's death.

However, if your annuity starting date is before 1998, do not use Table 2 and do not combine the annuitants' ages. Instead, you must use Table 1 at the bottom of the worksheet and enter on line 3 the number shown for the primary annuitant's age on the annuity starting date. This number will differ depending on whether your annuity starting date is before November 19, 1996, or after November 18, 1996.

Fixed period annuity. If your annuity does not depend on anyone's life expectancy, the total number of expected monthly payments to enter on line 3 of the worksheet is the number of monthly annuity payments under the contract.

Example. Bill Kirkland, age 65, began receiving retirement benefits in 2000 under a joint and survivor annuity. Bill's annuity starting date is January 1, 2000. The benefits are to be paid for the joint lives of Bill and his wife, Kathy, age 65. Bill had contributed $31,000 to a qualified plan and had received no distributions before the annuity starting date. Bill is to receive a retirement benefit of $1,200 a month, and Kathy is to receive a monthly survivor benefit of $600 upon Bill's death.

Bill must use the Simplified Method to figure his taxable annuity because his payments are from a qualified plan and he is under age 75. Because his annuity is payable over the lives of more than one annuitant, he uses his and Kathy's combined ages and Table 2 at the bottom of the worksheet in completing line 3 of the worksheet. His completed worksheet follows.

Example -- Bill Kirkland

Bill's tax-free monthly amount is $100 ($31,000 x 310 as shown on line 4 of the worksheet). Upon Bill's death, if Bill has not recovered the full $31,000 investment, Kathy will also exclude $100 from her $600 monthly payment. The full amount of any annuity payments received after 310 payments are paid must be included in gross income.

If Bill and Kathy die before 310 payments are made, a miscellaneous itemized deduction will be allowed for the unrecovered cost on the final income tax return of the last to die. This deduction is not subject to the 2%-of-adjusted-gross-income limit.

Multiple annuitants. If you and one or more other annuitants receive payments at the same time, you exclude from each annuity payment a pro-rata share of the monthly tax-free amount. Figure your share in the following steps.

1. Complete your worksheet through line 4 to figure the monthly tax-free amount.
2. Divide the amount of the your monthly payment by the total amount of the monthly payments to all annuitants.
3. Multiply the amount on line 4 of your worksheet by the amount figured in (2) above. The result is your share of the monthly tax-free amount.

Replace the amount on line 4 of the worksheet with the result in (3) above. Enter that amount on line 4 of your worksheet each year.

General Rule

Under the General Rule, you determine the tax-free part of each annuity payment based on the ratio of the cost of the contract to the total expected return. Expected return is the total amount you and other eligible annuitants can expect to receive under the contract. To figure it, you must use life expectancy (actuarial) tables prescribed by the IRS.

Who must use the General Rule. You must use the General Rule if you receive pension or annuity payments from:

1. A nonqualified plan (such as a private annuity, a purchased commercial annuity, or a nonqualified employee plan), or
2. A qualified plan if you are age 75 or older on your annuity starting date and your annuity payments are guaranteed for at least 5 years.

Annuity starting before November 19, 1996. If your annuity starting date is after July 1, 1986, and before November 19, 1996, you had to use the General Rule for either circumstance described above. You also had to use it for any fixed period annuity. If you did not have to use the General Rule, you could have chosen to use it. If your annuity starting date is before July 2, 1986, you had to use the General Rule unless you could use the Three-Year Rule.

If you had to use the General Rule (or chose to use it), you must continue to use it each year that you recover your cost.

Who cannot use the General Rule. You cannot use the General Rule if you receive your pension or annuity from a qualified plan and none of the circumstances described in the preceding discussions apply to you. See Simplified Method, earlier.

More information. For complete information on using the General Rule, including the actuarial tables you need, see Publication 939.

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