This section summarizes the tax treatment of amounts you receive from certain individual retirement arrangements, employee pensions or annuities, and disability pensions or annuities. More detailed information can be found in Publication 590, Individual Retirement Arrangements (IRAs), or Publication 575, Pension and Annuity Income.

Individual Retirement Arrangements (IRAs)

In general, include distributions from a traditional IRA in your gross income in the year you receive them. A traditional IRA is any IRA that is not a Roth or SIMPLE IRA. Exceptions to the general rule are rollovers and tax-free withdrawals of contributions, and the return of nondeductible contributions discussed in Publication 590.

If you made nondeductible contributions to a traditional IRA, you must file Form 8606, Nondeductible IRAs and Coverdell ESAs. If you do not file Form 8606 with your return, you may have to pay a $50 penalty. Also, when you receive distributions from your traditional IRA, the amounts will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made.

For more information on IRAs, see Publication 590.

Early distributions. Generally, early distributions are amounts distributed from your traditional IRA account, pension, or annuity, before you are age 59 1/2, or amounts you receive when you cash in retirement bonds before you are age 59 1/2. You must include early distributions of taxable amounts in your gross income. These taxable amounts are also subject to an additional 10% tax unless the distribution qualifies as an exception. See Tax on Early Distributions, later.

After age 59 1/2 and before age 70 1/2. After you reach age 59 1/2, you can receive distributions from your traditional IRA without having to pay the 10% additional tax. Even though you can receive distributions after you reach age 59 1/2, distributions are not required until April 1 of the year following the year in which you reach age 70 1/2.

Required distributions. If you are the owner of a traditional IRA, you must receive the entire balance in your IRA or start receiving periodic distributions from your IRA by April 1 of the year following the year in which you reach age 70 1/2. See When Must I Withdraw IRA Assets? (Required Distributions) in Publication 590. If distributions from your traditional IRA(s) are less than the required minimum distribution for the year, you may have to pay a 50% excise tax for that year on the amount not distributed as required. See Tax on Excess Accumulation, later.

Pensions and Annuities

Generally, if you did not pay any part of the cost of your employee pension or annuity, and your employer did not withhold part of the cost of the contract from your pay while you worked, the amounts you receive each year are fully taxable.

If you have a cost to recover from your pension or annuity plan, (see Cost, later), 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.

Exclusion limit. If you contributed to your pension or annuity and your annuity starting date is before 1987, you can continue to take your monthly exclusion for as long as you receive your annuity. The total exclusion may be more than your cost.

If your annuity starting date is after 1986, the total amount of annuity income you can exclude over the years as a recovery of the cost cannot exceed your total cost.

In either case, 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 on miscellaneous deductions.

Cost. Before you can figure how much, if any, of your pension or annuity benefits is taxable, you must determine your cost in the plan (your investment). In general, your cost is your net investment in the contract as of the annuity starting date. This includes amounts your employer contributed that were taxable when paid.

From this total cost paid or considered paid by you, subtract any refunded premiums, rebates, dividends, unrepaid loans, or other tax-free amounts you received by the later of the annuity starting date or the date on which you received your first payment.

The annuity starting date is the later of the first day of the first period for which you received a payment from the plan or the date on which the plan's obligations became fixed.

Generally, the amount of your contributions to the plan may be shown in box 9b of any Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc, that you receive.

Foreign employment contributions. If you worked abroad, certain amounts your employer paid into your retirement plan may be considered part of your cost. For details, see Foreign employment contributions in Publication 575.

Withholding. The payer of your pension, profit-sharing, stock bonus, annuity, or deferred compensation plan will withhold income tax on the taxable part of amounts paid to you. You can choose not to have tax withheld except for amounts paid to you that are eligible rollover distributions. See Withholding Tax and Estimated Tax and Rollovers in Publication 575 for more information.

For payments other than eligible rollover distributions, you can tell the payer how to withhold by filing a Form W-4P, Withholding Certificate for Pension or Annuity Payments.

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 over 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 generally must use the Simplified Method if your annuity starting date is after November 18, 1996, and you receive your pension or annuity payments from a qualified plan or annuity.

In addition, if your annuity starting date is after July 1, 1986, and before November 19, 1996, you generally could have chosen to use the Simplified Method for payments from a qualified plan.

Who cannot use the Simplified Method. You cannot use the Simplified Method and must use the General Rule if you receive pension or annuity payments from:

• A nonqualified plan (such as a private annuity, a purchased commercial annuity, or a nonqualified employee plan), or
• 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.

In addition, you must use the General Rule for payments from a qualified plan if your annuity starting date is after July 1, 1986, and before November 19, 1996, and you did not choose to use the Simplified Method. (You also must use the General Rule for payments from a qualified plan if your annuity starting date is before July 2, 1986, and you did not qualify to use the Three-Year Rule.)

Complete information on the General Rule, including the tables you need, is contained in Publication 939, General Rule for Pensions and Annuities.

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 less than 5 years of guaranteed payments.

How to use the Simplified Method. Complete the Simplified Method Worksheet in the Form 1040 or Form 1040A instructions or in Publication 575 to figure your taxable annuity for 2001. If the annuity is payable only over your life, use your age on your annuity starting date to complete line 3 of the worksheet. If your annuity is payable over your life and the lives of other individuals, use your combined ages on the annuity starting date. (However, if your annuity starting date is before 1998, use the primary annuitant's age on the annuity starting date.) If the annuity does not depend on anyone's life expectancy, use the total number of monthly annuity payments under the contract.

Be sure to keep a copy of the completed worksheet; it will help you figure your taxable annuity in later years.

Example. Bill Kirkland, age 65, began receiving retirement benefits in January 2001, under a joint and survivor annuity. Bill's annuity starting date is January 1, 2001. The benefits are to be paid over 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. (See his illustrated completed Simplified Method Worksheet.)

His annuity is payable over the lives of more than one annuitant, so Bill uses his and Kathy's combined ages and Table 2 at the bottom of the worksheet in completing line 3 of the worksheet. Bill's tax-free monthly amount is $100 ($31,000 × 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.

Example 1 — Illustrated Simplified Method Worksheet for Bill Kirkland

Survivors. If you receive a survivor annuity because of the death of a retiree who had reported the annuity under the Three-Year Rule, include the total received in your income. (The retiree's cost has already been recovered tax free.)

If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage the retiree used to your initial payment called for in the contract. The resulting tax-free amount will then remain fixed. Any increases in the survivor annuity are fully taxable.

If the retiree was reporting the annuity payments under the Simplified Method, the part of each payment that is tax free is the same as the tax-free amount figured by the retiree at the annuity starting date. See Simplified Method, earlier.

How to report. If you file Form 1040, report your total annuity on line 16a, and the taxable part on line 16b. If your pension or annuity is fully taxable, enter it on line 16b. Do not make an entry on line 16a. For example, if you received monthly payments totaling $1,200 during 2001 from a pension plan that was completely financed by your employer, and you had paid no tax on the payments that your employer made to the plan, the entire $1,200 is taxable. You include $1,200 on line 16b, Form 1040.

If you file Form 1040A, report your total annuity on line 12a, and the taxable part on line 12b. If your pension or annuity is fully taxable, enter it on line 12b. Do not make an entry on line 12a.

Joint return. If you file a joint return and you and your spouse each receive one or more pensions or annuities, report the total of the pensions and annuities on line 16a, Form 1040, or line 12a, Form 1040A, and report the taxable part on line 16b, Form 1040, or line 12b, Form 1040A.

Form 1099-R. You should receive a Form 1099-R for your pension or annuity. Form 1099-R shows your pension or annuity for the year and any income tax withheld.

Nonperiodic Distributions

If you receive a nonperiodic distribution from your retirement plan, you may be able to exclude all or part of it from your income as a recovery of your cost. Nonperiodic distributions include cash withdrawals, distributions of current earnings, and certain loans. For information on how to figure the taxable amount of a nonperiodic distribution, see Taxation of Nonperiodic Payments in Publication 575.

The taxable part of a nonperiodic distribution may be subject to an additional 10% tax. See Tax on Early Distributions, later.

Lump-sum distributions. If you receive a lump-sum distribution from a qualified employee plan or qualified employee annuity and the plan participant was born before 1936, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify as capital gain subject to a 20% tax rate. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 10-year tax option to figure tax on the ordinary income part.

The 5-year tax option for figuring the tax on lump-sum distributions has been repealed.

Form 1099-R. If you receive a total distribution from a plan, you should receive a Form 1099-R. If the distribution qualifies as a lump-sum distribution, box 3 shows the capital gain. The amount in box 2a minus the amount in box 3 is the ordinary income.

For more detailed information on lump-sum distributions, get Publication 575 or Form 4972, Tax on Lump-Sum Distributions.

Tax on Early Distributions

Most distributions you receive from your qualified retirement plan or deferred annuity contract before you reach age 59 1/2 are subject to an additional tax of 10%. The tax applies to the taxable part of the distribution.

For this purpose, a qualified retirement plan is:

1. A qualified employee plan,
2. A qualified employee annuity plan,
3. A tax-sheltered annuity plan (403(b) plan), or
4. An IRA.

5% rate on certain early distributions from deferred annuity contracts. If an early withdrawal from a deferred annuity is otherwise subject to the 10% additional tax, a 5% rate may apply instead. A 5% rate applies to distributions under a written election providing a specific schedule for the distribution of your interest in the contract if, as of March 1, 1986, you had begun receiving payments under the election. On line 4 of Form 5329, multiply by 5% instead of 10%. Attach an explanation to your return.

Exceptions to tax. The early distribution tax does not apply to any distribution that meets one of the following exceptions.

General exceptions. The tax does not apply to distributions that are:

• Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from a qualified retirement plan, the payments must begin after separation from service),
• Made because you are totally and permanently disabled, or
• Made on or after the death of the plan participant or contract holder.

Additional exceptions for qualified retirement plans. The tax does not apply to distributions that are:

• From a qualified retirement plan after your separation from service in or after the year you reached age 55,
• From a qualified retirement plan to an alternate payee under a qualified domestic relations order,
• From a qualified retirement plan to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
• From an employer plan under a written election that provides a specific schedule for distribution of your entire interest if, as of March 1, 1986, you had separated from service and had begun receiving payments under the election,
• From an employee stock ownership plan for dividends on employer securities held by the plan, or
• From a qualified retirement plan due to an IRS levy of the plan.

Additional exceptions for nonqualified annuity contracts. The tax does not apply to distributions that are:

• From a deferred annuity contract to the extent allocable to investment in the contract before August 14, 1982,
• From a deferred annuity contract under a qualified personal injury settlement,
• From a deferred annuity contract purchased by your employer upon termination of a qualified employee plan or qualified employee annuity plan and held by your employer until your separation from service, or
• From an immediate annuity contract (a single premium contract providing substantially equal annuity payments that start within one year from the date of purchase and are paid at least annually).

Reporting tax or exception. If distribution code 1 (early distribution, no known exception) is shown in box 7 of Form 1099-R, multiply the taxable part of the early distribution by 10% and enter the result on line 55 of Form 1040. Write "No" on the dotted line. You do not have to file Form 5329.

You do not have to file Form 5329 if you qualify for an exception to the 10% tax and distribution code 2, 3, or 4 is shown in box 7 of Form 1099-R. However, you must file Form 5329 if the code is not shown or the code shown is incorrect (for example, code 1 is shown although you meet an exception).

Tax on Excess Accumulation

To make sure that most of your retirement benefits are paid to you during your lifetime, rather than to your beneficiaries after your death, the payments that you receive from qualified retirement plans generally must begin no later than your required beginning date (unless the rule for 5% owners applies). This is April 1 of the year that follows the later of:

• The calendar year in which you reach age 70 1/2, or
• The calendar year in which you retire.

For this purpose, a qualified retirement plan includes a:

• Qualified employee plan,
• Qualified employee annuity plan,
• Section 457 deferred compensation plan, or
• Tax-sheltered annuity plan (403(b) plan) (for benefits accruing after 1986).

5% owners. If you own more than 5% of the company maintaining your qualified retirement plan, you must begin to receive distributions by April 1 of the year after the calendar year in which you reach age 70 1/2.

Amount of tax. If you do not receive the required minimum distribution, you are subject to an additional tax. The tax equals 50% of the difference between the amount that must be distributed and the amount that was distributed during the tax year. You can get this excise tax excused if you establish that the shortfall in distributions was due to reasonable error and that you are taking reasonable steps to remedy the shortfall.

Form 5329. You must file a Form 5329 if you owe a tax because you did not receive a minimum required distribution from your qualified retirement plan.

Additional information. For more detailed information on the tax on excess accumulation, see Publication 575.

Railroad Retirement Benefits

Benefits paid under the Railroad Retirement Act fall into two categories. These categories are treated differently for income tax purposes.

Tier 1. The first category is the amount of tier 1 railroad retirement benefits that equals the social security benefit that a railroad employee or beneficiary would have been entitled to receive under the social security system. This part of the tier 1 benefit is the social security equivalent benefit (SSEB) and is treated (for tax purposes) like social security benefits. (See Social Security and Equivalent Railroad Retirement Benefits, later.)

Non-social security equivalent benefits. The second category consists of the rest of the tier 1 benefits, called the non-social security equivalent benefit (NSSEB), and any tier 2 benefit, vested dual benefit (VDB), and supplemental annuity benefit. This category of benefits is treated as an amount received from a qualified employer plan. This allows for the tax-free (nontaxable) recovery of employee contributions from the tier 2 benefits and the NSSEB part of the tier 1 benefits. Vested dual benefits and supplemental annuity benefits are fully taxable.

For more information about railroad retirement benefits, see Publication 575.

Military Retirement Pay

Military retirement pay based on age or length of service is taxable and must be included in income as a pension on lines 16a and 16b of Form 1040 or on lines 12a and 12b of Form 1040A. But certain military and government disability pensions that are based on a percentage of disability from active service in the Armed Forces of any country are generally not taxable.

Veterans' benefits and insurance are discussed in Publication 525.

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