What is not covered in this chapter.

The following topics are not discussed in this chapter:

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 35.

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.

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.

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:

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.

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 2003. 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.

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.

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.

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.

How to treat the distribution.

If you receive a lump-sum distribution, you may have the following options for how you treat the taxable part.

The first three options are explained in the following discussions.

Electing optional lump-sum treatment.

You can choose to use the 10-year tax option or capital gain treatment only once after 1986 for any plan participant. If you make this choice, you cannot use either of these optional treatments for any future distributions for the participant.

Taxable and tax-free parts of the distribution.

The taxable part of a lump-sum distribution is the employer's contributions and income earned on your account. You may recover your cost in the lump sum and any net unrealized appreciation (NUA) in employer securities tax free.

Cost.

In general, your cost is the total of:

You must reduce this cost by amounts previously distributed tax free.

NUA.

The NUA in employer securities (box 6 of Form 1099–R) received as part of a lump-sum distribution is generally tax free until you sell or exchange the securities. (For more information, see Distributions of employer securities under Taxation of Nonperiodic Payments, in Publication 575.)

Eligible rollover distributions.

Generally, you can roll over any part of most nonperiodic distributions from a qualified retirement plan.

Rollover of nontaxable amounts.

You may be able to roll over the nontaxable part of a distribution (such as your after-tax contributions) made to another qualified retirement plan or traditional IRA. The transfer must be made either through a direct rollover to a qualified plan that separately accounts for the taxable and nontaxable parts of the rollover or through a rollover to a traditional IRA.

If you roll over only part of a distribution that includes both taxable and nontaxable amounts, the amount you roll over is treated as coming first from the taxable part of the distribution.

Hardship distributions.

Hardship distributions are no longer treated as eligible rollover distributions.

Additional exceptions.

For more information about exceptions to eligible rollover distributions, see Publication 575.

Direct rollover option.

You can choose to have the administrator of your old plan transfer the distribution directly from your old plan to the new plan (if permitted) or traditional IRA. If you decide on a rollover, it is generally to your advantage to choose this direct rollover option. Under this option, the plan administrator would not withhold tax from your distribution.

Withholding tax.

If you choose to have the distribution paid to you, it is taxable in the year distributed unless you roll it over to a new plan or IRA within 60 days. The plan administrator must withhold income tax of 20% from the taxable distribution paid to you. (See Pensions and Annuities under Withholding in chapter 5.)

If you decide to roll over an amount equal to the distribution before withholding, your contribution to the new plan or IRA must include other money (for example, from savings or amounts borrowed) to replace the amount withheld.

The administrator must give you a written explanation of your distribution options within a reasonable period of time before making an eligible rollover distribution.

Rollover by surviving spouse.

You may be able to roll over tax free all or part of a distribution from a qualified retirement plan you receive as the surviving spouse of a deceased employee. The rollover rules apply to you as if you were the employee. You can roll over a distribution into a qualified retirement plan or a traditional IRA.

A beneficiary other than the employee's surviving spouse cannot roll over a distribution.

Alternate payee under qualified domestic relations order.

You may be able to roll over all or any part of a distribution from a qualified retirement plan that you receive under a qualified domestic relations order (QDRO). If you receive the distribution as an employee's spouse or former spouse (not as a nonspousal beneficiary), the rollover rules apply to you as if you were the employee. You can roll over the distribution from the plan into a traditional IRA or to another eligible retirement plan. See Publication 575 for more information on benefits received under a QDRO.

Retirement bonds.

If you redeem a retirement bond, you can defer the tax on the amount received by rolling it over to an IRA or qualified employer plan as discussed in Publication 590. For more information on the rules for rolling over distributions, see Publication 575.

For this purpose, a qualified retirement plan is:

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

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 must begin no later than on your required beginning date (defined next).

Unless the rule for 5% owners applies, you must begin to receive distributions from your qualified retirement plan by April 1 of the year that follows the later of:

However, your plan may require you to begin to receive distributions by April 1 of the year that follows the year in which you reach age 701/, even if you have not retired.

For this purpose, a qualified retirement plan includes a:

Sale of annuity.

Gain on the exchange of an annuity contract is ordinary income to the extent that the gain is due to interest accumulated on the contract and the exchange is for a life insurance or endowment contract. You do not recognize gain or loss on an exchange of an annuity contract solely for another annuity contract if the insured or annuitant remains the same. See Transfers of Annuity Contracts in Publication 575 for more information about exchanges of annuity contracts.