Retirement Plans, Pensions, and Annuities

Important Changes

Rollovers to and from qualified retirement plans.   For distributions made after 2001, for rollover purposes, tax-sheltered annuity plans (403(b) plans) and eligible state or local government section 457 deferred compensation plans are qualified retirement plans. See Rollovers.

Hardship distribution rollovers.   A hardship distribution made after 2001 from any retirement plan is not an eligible rollover distribution. See Rollovers.

Time for making rollover.   The 60-day period for completing the rollover of an eligible rollover distribution may be extended for distributions made after 2001 in certain cases of casualty, disaster, or other events beyond your reasonable control. See Rollovers.

Rollover by surviving spouse.   You may be able to roll over a distribution made after 2001 you receive as the surviving spouse of a deceased employee into a qualified retirement plan or a traditional IRA. See Rollovers.

Eligible rollover distribution.   You may be able to roll over the nontaxable part of a retirement plan distribution made after 2001 to another qualified retirement plan or a traditional IRA. See Rollovers.

Section 457 plan early distributions.   The tax on early distributions may apply to certain distributions made from an eligible state or local government section 457 deferred compensation plan after 2001. See Tax on Early Distributions.

Introduction

This chapter discusses the tax treatment of distributions you receive from:

1. An employee pension or annuity from a qualified plan,
2. A disability retirement, and
3. A purchased commercial annuity.

What is not covered in this chapter.   The following topics are not discussed in this chapter:

1. The General Rule. This is the method generally used to determine the tax treatment of pension and annuity income from nonqualified plans (including commercial annuities). If your annuity starting date is after November 18, 1996, you generally cannot use the General Rule for a qualified plan. For more information about the General Rule, see Publication 939.
2. Civil service retirement benefits. If you are retired from the federal government (either regular or disability retirement), see Publication 721, Tax Guide to U.S. Civil Service Retirement Benefits. Publication 721 also covers the information that you need if you are the survivor or beneficiary of a federal employee or retiree who died.
3. Individual retirement arrangements (IRAs). Information on the tax treatment of amounts you receive from an IRA is in chapter 18.

Useful Items You may want to see:

Publication

• 575   Pension and Annuity Income
• 721   Tax Guide to U.S. Civil Service Retirement Benefits
• 939   General Rule for Pensions and Annuities

Form (and Instructions)

• W-4P   Withholding Certificate for Pension or Annuity Payments
• 1099-R   Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
• 4972   Tax on Lump-Sum Distributions
• 5329   Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts

Employee 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 from your pay while you worked, the amounts you receive each year are fully taxable. You must report them on your income tax return.

Partly taxable payments.   If you paid part of the cost of your annuity, you are not taxed on the part of the annuity you receive that represents a return of your cost. The rest of the amount you receive is taxable. Your annuity starting date (defined later) determines which method you must or may use.

If you contributed to your pension or annuity plan, you figure the tax-free and the taxable parts of your annuity payments under either the Simplified Method or the General Rule. If your annuity starting date is after November 18, 1996, and your payments are from a qualified plan, you must use the Simplified Method. Generally, you must use the General Rule only for nonqualified plans.

If your annuity is paid under a qualified plan and your annuity starting date is after July 1, 1986, but before November 19, 1996, you can use either the General Rule or, if you qualify, the Simplified Method.

More than one program.   If you receive benefits from more than one program, such as a pension plan and a profit-sharing plan, you may have to figure the taxable part of each separately. You may have to make separate computations even if the benefits from both are included in the same check. For example, benefits from one of your programs could be fully taxable, while the benefits from your other program could be taxable under the General Rule or the Simplified Method. Your former employer or the plan administrator should be able to tell you if you have more than one pension or annuity contract.

Railroad retirement benefits.   Part of the railroad retirement benefits you receive is treated for tax purposes like social security benefits, and part is treated like an employee pension. For information about railroad retirement benefits treated as social security benefits, see Publication 915, Social Security and Equivalent Railroad Retirement Benefits. For information about railroad retirement benefits treated as an employee pension, see Railroad Retirement in Publication 575.

Credit for the elderly or the disabled.   If you receive a pension or annuity, you may be able to take the credit for the elderly or the disabled. See chapter 34.

Withholding and estimated tax.   The payer of your pension, profit-sharing, stock bonus, annuity, or deferred compensation plan will withhold income tax on the taxable parts 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 Eligible rollover distributions under Rollovers, later. You make this choice by filing Form W-4P.

For payments other than eligible rollover distributions, you can tell the payer how to withhold by filing Form W-4P. If an eligible rollover distribution is paid directly to you, 20% will generally be withheld. There is no withholding on a direct rollover of an eligible rollover distribution. See Direct rollover option under Rollovers, later. If you choose not to have tax withheld or you do not have enough tax withheld, you may have to pay estimated tax.

For more information, see Pensions and Annuities under Withholding in chapter 5.

Loans.   If you borrow money from your qualified pension or annuity plan, tax-sheltered annuity program, government plan, or contract purchased under any of these plans, you may have to treat the loan as a nonperiodic distribution. This means that you may have to include in income all or part of the amount borrowed unless certain exceptions apply. Even if you do not have to treat the loan as a nonperiodic distribution, you may not be able to deduct the interest on the loan in some situations. For details, see Loans Treated as Distributions in Publication 575. For information on the deductibility of interest, see chapter 25.

Qualified plans for self-employed individuals.   Qualified plans set up by self-employed individuals are sometimes called Keogh or H.R. 10 plans. Qualified plans can be set up by sole proprietors, partnerships (but not a partner), and corporations. They can cover self-employed persons, such as the sole proprietor or partners, as well as regular (common-law) employees.

Distributions from a qualified plan are usually fully taxable because most recipients have no cost basis. If you have an investment (cost) in the plan, however, your pension or annuity payments from a qualified plan are taxed under the Simplified Method. For more information about qualified plans, see Publication 560, Retirement Plans for Small Business.

Section 457 deferred compensation plans.   If you work for a state or local government or for a tax-exempt organization, you may be able to participate in a section 457 deferred compensation plan. If your plan is an eligible plan, you are not taxed currently on pay that is deferred under the plan or on any earnings from the plan's investment of the deferred pay. You are taxed on amounts deferred in an eligible state or local government plan only when they are distributed from the plan. You are taxed on amounts deferred in an eligible tax-exempt organization plan when they are distributed or otherwise made available to you.

This chapter covers the tax treatment of benefits under eligible section 457 plans, but it does not cover the treatment of deferrals. For information on deferrals under section 457 plans, see Retirement Plan Contributions under Employee Compensation in Publication 525.

For general information on these deferred compensation plans, see Section 457 Deferred Compensation Plans in Publication 575.

Cost (Investment in the Contract)

Before you can figure how much, if any, of your pension or annuity benefits is taxable, you must determine your cost (your investment in the contract). Your total cost in the plan includes everything that you paid. It also includes amounts your employer paid that were taxable at the time paid. Cost does not include any amounts you deducted or excluded from income.

From this total cost paid or considered paid by you, subtract any refunds of 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.

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

Your employer or the organization that pays you the benefits (plan administrator) should show your cost in Box 5 of your Form 1099-R.

Foreign employment contributions.   If you worked in a foreign country and your employer contributed to your retirement plan, a part of those payments may be considered part of your cost. For more information about foreign employment contributions, see Publication 575.

Simplified Method

Under the Simplified Method, you figure the tax-free part of each monthly annuity payment by dividing your cost by the total number of expected 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 receive pension or annuity payments from a qualified plan or annuity, unless you were at least 75 years old and entitled to annuity payments from a qualified plan that are guaranteed for 5 years or more.

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 Who must use the Simplified Method, earlier.

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

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.

If you are the survivor of a deceased retiree, you can use the Simplified Method if the retiree used it.

Exclusion limit.   Your annuity starting date determines the total amount that you can exclude from your taxable 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.

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.

How to use it.   Complete the Simplified Method Worksheet to figure your taxable annuity for 2002. If the annuity is payable only over your life, use your age at the birthday preceding your annuity starting date. For annuity starting dates beginning in 1998, if your annuity is payable over your life and the lives of other individuals, use your combined ages at the birthdays preceding the annuity starting date.

If your annuity starting date begins in 1998 and your annuity is payable over the lives of more than one annuitant, the total number of monthly annuity payments expected to be received is based on the combined ages of the annuitants at the annuity starting date. However, if your annuity starting date began before January 1, 1998, the total number of monthly annuity payments expected to be received is based on the primary annuitant's age at the annuity starting date.

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 on January 1, 2002, under a joint and survivor annuity. Bill's annuity starting date is January 1, 2002. 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 is shown in Worksheet 11-A.

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.

Had Bill's retirement annuity payments been from a nonqualified plan, he would have used the General Rule. He uses the Simplified Method Worksheet because his annuity payments are from a qualified plan.

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 income. (The retiree's cost has already been recovered tax free.)

If the retiree was reporting the annuity payments under the General Rule, 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.

In any case, if the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost.

If you are the survivor of an employee, or former employee, who died before becoming entitled to any annuity payments, you must figure the taxable and tax-free parts of your annuity payments using the method that applies as if you were the employee.

Estate tax.   If your annuity was a joint and survivor annuity that was included in the decedent's estate, an estate tax may have been paid on it. You can deduct, as a miscellaneous itemized deduction, the part of the total estate tax that was based on the annuity. This deduction is not subject to the 2%-of- adjusted-gross-income limit. The deceased annuitant must have died after the annuity starting date. (For details, see section 1.691(d)-1 of the regulations.) This amount cannot be deducted in one year. It must be deducted in equal amounts over your remaining life expectancy.

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.

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.

More than one annuity.   If you receive more than one annuity and at least one of them is not fully taxable, enter the total amount received from all annuities on line 16a, Form 1040, or line 12a, Form 1040A, and enter the taxable part on line 16b, Form 1040, or line 12b, Form 1040A. If all the annuities you receive are fully taxable, enter the total of all of them on line 16b, Form 1040, or line 12b, Form 1040A.

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.

Worksheet 11-A. Simplified Method Worksheet for Bill Kirkland (Keep for Your Records)

1.	Enter the total pension or annuity payments received this year. Also, add this amount to the total for Form 1040, line 16a, or Form 1040A, line 12a			1.	14,400
2.	Enter your cost in the plan (contract) at the annuity starting date	2.	31,000
	Note: If your annuity starting date was before this year and you completed this worksheet last year, skip line 3 and enter the amount from line 4 of last year's worksheet on line 4 below. Otherwise, go to line 3.
3.	Enter the appropriate number from Table 1 below. But if your annuity starting date was after 1997 and the payments are for your life and that of your beneficiary, enter the appropriate number from Table 2 below	3.	310
4.	Divide line 2 by the number on line 3	4.	100
5.	Multiply line 4 by the number of months for which this year's payments were made. If your annuity starting date was before 1987, enter this amount on line 8 below and skip lines 6, 7, 10, and 11. Otherwise, go to line 6	5.	1,200
6.	Enter any amounts previously recovered tax free in years after 1986	6.	-0-
7.	Subtract line 6 from line 2	7.	31,000
8.	Enter the smaller of line 5 or line 7			8.	1,200
9.	Taxable amount for year. Subtract line 8 from line 1. Enter the result, but not less than zero. Also, add this amount to the total for Form 1040, line 16b, or Form 1040A, line 12b.			9.	13,200
	Note: If your Form 1099-R shows a larger taxable amount, use the amount on line 9 instead.
10.	Add lines 6 and 8			10.	1,200
11.	Balance of cost to be recovered. Subtract line 10 from line 2			11.	29,800

TABLE 1 FOR LINE 3 ABOVE
	AND your annuity starting date was -
IF the age at annuity starting date was...	before November 19, 1996, enter on line 3...	after November 18, 1996, enter on line 3...
55 or under	300	360
56-60	260	310
61-65	240	260
66-70	170	210
71 or older	120	160
TABLE 2 FOR LINE 3 ABOVE
IF the combined ages at annuity starting date were...		THEN enter on line 3...
110 or under		410
111-120		360
121-130		310
131-140		260
141 or older		210

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