The tax rules in this publication apply both to annuities that provide fixed payments and to annuities that provide payments that vary in amount based on investment results or other factors. For example, they apply to commercial variable annuity contracts, whether bought by an employee retirement plan for its participants or bought directly from the issuer by an individual investor. Under these contracts, the owner can generally allocate the purchase payments among several types of investment portfolios or mutual funds and the contract value is determined by the performance of those investments. The earnings are not taxed until distributed either in a withdrawal or in annuity payments. The taxable part of a distribution is treated as ordinary income.

For information on the tax treatment of a transfer or exchange of a variable annuity contract, see Transfers of Annuity Contracts under Taxation of Nonperiodic Payments, later.

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 publication 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.

If you retired on disability, you generally must include in income any disability pension you receive under a plan that is paid for by your employer. You must report your taxable disability payments as wages on line 7 of Form 1040 or Form 1040A or on line 8 of Form 1040NR until you reach minimum retirement age . Minimum retirement age generally is the age at which you can first receive a pension or annuity if you are not disabled.

Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on Form 1040, lines 16a and 16b; Form 1040A, lines 12a and 12b; or on Form 1040NR, lines 17a and 17b.

If you are an eligible retired public safety officer (law enforcement officer, firefighter, chaplain, or member of a rescue squad or ambulance crew), you can elect to exclude from income distributions made from your eligible retirement plan that are used to pay the premiums for accident or health insurance or long-term care insurance. The premiums can be for coverage for you, your spouse, or dependents. The distribution must be made directly from the plan to the insurance provider. You can exclude from income the smaller of the amount of the insurance premiums or $3,000. You can only make this election for amounts that would otherwise be included in your income. The amount excluded from your income cannot be used to claim a medical expense deduction.

An eligible retirement plan is a governmental plan that is:

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

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 you treat it for tax purposes like social security benefits. If you received or repaid the SSEB portion of tier 1 benefits during 2006, you will receive Form RRB-1099 , Payments by the Railroad Retirement Board (or Form RRB-1042S , Statement for Nonresident Aliens of Payments by the Railroad Retirement Board, if you are a nonresident alien) from the U.S. Railroad Retirement Board (RRB).

For more information about the tax treatment of the SSEB portion of tier 1 benefits and Forms RRB-1099 and RRB-1042S, see Publication 915.

The second category contains the rest of the tier 1 railroad retirement benefits, called the non-social security equivalent benefit (NSSEB). It also contains any tier 2 benefit, vested dual benefit (VDB), and supplemental annuity benefit. Treat this category of benefits, shown on Form RRB-1099-R, as an amount received from a qualified employee 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. (NSSEB and tier 2 benefits, less certain repayments, are combined into one amount called the Contributory Amount Paid on Form RRB-1099-R.) Vested dual benefits and supplemental annuity benefits are fully taxable. See Taxation of Periodic Payments, later, for information on how to report your benefits and how to recover the employee contributions tax free. Form RRB-1099-R is used for U.S. citizens, resident aliens, and nonresident aliens.

Form RRB-1099-R.   The following discussion explains the items shown on Form RRB-1099-R. The amounts shown on this form are before any deduction for:

• Federal income tax withholding,

• Medicare premiums,

• Legal process garnishment payments,

• Legal process assignment payments,

• Recovery of a prior year overpayment of an NSSEB, tier 2 benefit, VDB, or supplemental annuity benefit, or

• Recovery of Railroad Unemployment Insurance Act benefits received while awaiting payment of your railroad retirement annuity.

  The amounts shown on this form are after any offset for:

• Social Security benefits,

• Age reduction,

• Public Service pensions or public disability benefits,

• Dual railroad retirement entitlement under another RRB claim number,

• Work deductions,

• Legal process partition deductions,

• Actuarial adjustment,

• Annuity waiver, or

• Recovery of a current-year overpayment of NSSEB, tier 2, VDB, or supplemental annuity benefits.

  The amounts shown on Form RRB-1099-R do not reflect any special rules, such as capital gain treatment or the special 10-year tax option for lump-sum payments, or tax-free rollovers. To determine if any of these rules apply to your benefits, see the discussions about them later.

  Generally, amounts shown on your Form RRB-1099-R are considered a normal distribution. Use distribution code “7” if you are asked for a distribution code.

  There are three copies of this form. Copy B is to be included with your income tax return if federal income tax is withheld. Copy C is for your own records. Copy 2 is filed with your state, city, or local income tax return, when required. See the illustrated Copy B (Form RRB-1099-R) above.

  

Each beneficiary will receive his or her own Form RRB-1099-R. If you receive benefits on more than one railroad retirement record, you may get more than one Form RRB-1099-R. So that you get your form timely, make sure the RRB always has your current mailing address.

  

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Form RRB–1099–R

Box 3—Employee Contributions.   This is the amount of taxes withheld from the railroad employee's earnings that exceeds the amount of taxes that would have been withheld had the earnings been covered under the social security system. This amount is the employee's cost (investment in the contract) that you use to figure the tax-free part of the NSSEB and tier 2 benefit you received (the amount shown in box 4). (For information on how to figure the tax-free part, see Partly Taxable Payments under Taxation of Periodic Payments, later.) The amount shown is the total employee contributions, not reduced by any amounts that the RRB calculated as previously recovered. It is the latest amount reported for 2006 and may have increased or decreased from a previous Form RRB-1099-R. If this amount has changed, you may need to refigure the tax-free part of your NSSEB/tier 2 benefit. If this box is blank, it means that the amount of your NSSEB and tier 2 payments shown in box 4 is fully taxable.

  

If you had a previous annuity entitlement that ended and you are figuring the tax-free part of your NSSEB/tier 2 benefit for your current annuity entitlement, you should contact the RRB for confirmation of your correct employee contributions amount.

Box 8—Repayments.   This amount represents any NSSEB, tier 2 benefit, VDB, and supplemental annuity benefit you repaid to the RRB in 2006 for years before 2006 or for unknown years. The amount shown in this box has not been deducted from the amounts shown in boxes 4, 5, and 6. It only includes repayments of benefits that were taxable to you. This means it only includes repayments in 2006 of NSSEB benefits paid after 1985, tier 2 and VDB benefits paid after 1983, and supplemental annuity benefits paid in any year. If you included the benefits in your income in the year you received them, you may be able to deduct the repaid amount. For more information about repayments, see Repayment of benefits received in an earlier year, later.

  

You may have repaid an overpayment of benefits by returning a payment, by making a payment, or by having an amount withheld.

Your retirement plan distributions are subject to federal income tax withholding. However, you can choose not to have tax withheld on payments you receive unless they are eligible rollover distributions. If you choose not to have tax withheld or if you do not have enough tax withheld, you may have to make estimated tax payments. See Estimated tax, later.

The withholding rules apply to the taxable part of payments you receive from:

For this purpose, a commercial annuity means an annuity, endowment, or life insurance contract issued by an insurance company.

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

Report the total amount you got on Form 1040, line 16b; Form 1040A, line 12b; or on Form 1040NR, line 17b. You should make no entry on Form 1040, line 16a; Form 1040A, line 12a; or Form 1040NR, line 17a.

If you have a cost to recover from your pension or annuity plan (see Cost (Investment in the Contract), earlier), 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.

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.

If you had more than one partly taxable pension or annuity, figure the tax-free part and the taxable part of each separately.

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 plans.

   1. A qualified employee plan.

   2. A qualified employee annuity.

   3. A tax-sheltered annuity plan (403(b) plan).

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 less 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 less 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 under Who must use the Simplified Method.

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 the Simplified Method.    Complete the worksheet in the back of this publication to figure your taxable annuity for 2006. 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 Smith, age 65, began receiving retirement benefits in 2006 under a joint and survivor annuity. Bill's annuity starting date is January 1, 2006. 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 on the next page.

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.

Worksheet A. Simplified Method Worksheet for Bill Smith

1.	Enter the total pension or annuity payments received this year. Also, add this amount to the total for Form 1040, line 16a; Form 1040A, line 12a; or Form 1040NR, line 17a	1.	$14,400
2.	Enter your cost in the plan (contract) at the annuity starting date plus any death benefit exclusion*	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 amount previously recovered tax free in years after 1986. This is the amount shown on line 10 of your worksheet for last year	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; Form 1040A, line 12b; or Form 1040NR, line 17b. Note: If your Form 1099-R shows a larger taxable amount, use the amount on this line instead	9.	$13,200
10.	Was your annuity starting date before 1987? □ Yes. STOP. Do not complete the rest of this worksheet. □ No. Add lines 6 and 8. This is the amount you have recovered tax free through 2006. You will need this number if you need to fill out this worksheet next year	10.	1,200
11.	Balance of cost to be recovered. Subtract line 10 from line 2. If zero, you will not have to complete this worksheet next year. The payments you receive next year will be fully taxable	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

* A death benefit exclusion (up to $5,000) applied to certain benefits received by employees who died before August 21, 1996.

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 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.

Qualified hurricane distributions.   If some, but not all, of the payments received are qualified hurricane distributions, complete two Simplified Method worksheets - one for qualified hurricane distributions and one for other distributions. Complete the worksheet for other distributions first. Enter on line 1 of the first worksheet only the distributions that are not qualified hurricane distributions. On line 5, multiply line 4 by the number of months you received payments that are not qualified hurricane distributions. Do not fill in line 11.

  After completing the first worksheet, enter the amount from line 10 of that worksheet on line 6 of the worksheet for qualified hurricane distributions. Complete lines 1 through 8 and 10 of the second worksheet. (The taxable amount of the qualified hurricane distribution will be figured on Form 8915.) Enter on line 1 of the second worksheet the amount from Form 8915, line 8. On line 5 of the second worksheet, multiply line 4 by the number of months you received payments that are qualified hurricane distributions. Carry the amount, if any, from line 8 of the second worksheet to Form 8915, line 9.

  

When you complete the Simplified Method worksheet for 2007, enter on line 6 the amount from line 10 of the second worksheet completed for 2006.

  If all of the payments are qualified hurricane distributions, complete lines 1 through 8 and 10 of one Simplified Method worksheet. (The taxable amount of the qualified hurricane distribution will be figured on Form 8915.) Enter on line 1 the amount from Form 8915, line 8. Carry the amount, if any, from line 8 of the worksheet to Form 8915, line 9.

  If you can only allocate a percentage of the distribution as a qualified hurricane distribution because of the dollar limitation, allocate your cost using the same percentage.

  For more information on qualified hurricane distributions, see Hurricane-Related Relief, later.

How you figure the taxable amount of a nonperiodic distribution depends on whether it is made before the annuity starting date or on or after the annuity starting date. If it is made before the annuity starting date, its tax treatment also depends on whether it is made under a qualified or nonqualified plan and, if it is made under a nonqualified plan, whether it fully discharges the contract or is allocable to an investment you made before August 14, 1982.

Distributions of employer securities.    If you receive a distribution of employer securities from a qualified retirement plan, you may be able to defer the tax on the net unrealized appreciation (NUA) in the securities. The NUA is the increase in the securities' value while they were in the trust. This tax deferral applies to distributions of the employer corporation's stocks, bonds, registered debentures, and debentures with interest coupons attached.

  If the distribution is a lump-sum distribution, tax is deferred on all of the NUA unless you choose to include it in your income for the year of the distribution.

   A lump-sum distribution for this purpose is the distribution or payment of a plan participant's entire balance (within a single tax year) from all of the employer's qualified plans of one kind (pension, profit-sharing, or stock bonus plans), but only if paid:

• Because of the plan participant's death,

• After the participant reaches age 59½,

• Because the participant, if an employee, separates from service, or

• After the participant, if a self-employed individual, becomes totally and permanently disabled.

  

If you choose to include NUA in your income for the year of the distribution and the participant was born before January 2, 1936, you may be able to figure the tax on the NUA using the optional methods described under Lump-Sum Distributions, later.

  If the distribution is not a lump-sum distribution, tax is deferred only on the NUA resulting from employee contributions other than deductible voluntary employee contributions.

  The NUA on which tax is deferred should be shown in box 6 of the Form 1099-R you receive from the payer of the distribution.

  When you sell or exchange employer securities with tax-deferred NUA, any gain is long-term capital gain up to the amount of the NUA. Any gain that is more than the NUA is long-term or short-term gain, depending on how long you held the securities after the distribution.

  Your basis in the employer securities is the total of the following amounts.

• Your contributions to the plan that are attributable to the securities.

• Your employer's contributions that were taxed as ordinary income in the year the securities were distributed.

• Your NUA in the securities that is attributable to employer contributions and taxed as ordinary income in the year the securities were distributed.

If you borrow money from your retirement plan, you must treat the loan as a nonperiodic distribution from the plan unless it qualifies for the exception explained below. This treatment also applies to any loan under a contract purchased under your retirement plan, and to the value of any part of your interest in the plan or contract that you pledge or assign (or agree to pledge or assign). It applies to loans from both qualified and nonqualified plans, including commercial annuity contracts you purchase directly from the issuer. Further, it applies if you renegotiate, extend, renew, or revise a loan that qualified for the exception below if the altered loan does not qualify. In that situation, you must treat the outstanding balance of the loan as a distribution on the date of the transaction.

You determine how much of the loan is taxable using the allocation rules for nonperiodic distributions discussed under Figuring the Taxable Amount, earlier. The taxable part may be subject to the additional tax on early distributions. It is not an eligible rollover distribution and does not qualify for the 10-year tax option.

Substantially level payments.   To qualify for this exception, the loan must require substantially level payments at least quarterly over the life of the loan. If the loan is from a designated Roth account, the payments must be satisfied separately for that part of the loan and for the part of the loan from other accounts under the plan. This level payment requirement does not apply to the period in which you are on a leave of absence without pay or on a rate of pay that is less than the required installment. Generally, this leave of absence must not be longer than 1 year. You must repay the loan within 5 years from the date of the loan (unless the loan was used to buy your main home). Your installment payments must not be less than your original payments.

  However, if your plan suspends your loan payments for any part of the period during which you are in the uniformed services, you will not be treated as having received a distribution even if the suspension is for more than 1 year and the term of the loan is extended. The loan payments must resume upon completion of such period and the loan must be repaid within 5 years from the date of the loan (unless the loan was used to buy your main home) plus the period of suspension.

  

If you were affected by Hurricane Katrina, Rita, or Wilma, see Hurricane-Related Relief , later.

Example 1.

On May 1, 2006, you borrowed $40,000 from your retirement plan. The loan was to be repaid in level monthly installments over 5 years. The loan was not used to buy your main home. You make nine monthly payments and start an unpaid leave of absence that lasts for 12 months. You were not in a uniformed service during this period. You must repay this loan by April 30, 2011 (5 years from the date of this loan). You can increase your monthly installments or you can make the original monthly installments and on April 30, 2011, pay the balance.

Example 2.

The facts are the same as in Example 1, except that you are on a leave of absence performing service in the uniformed services for 2 years. The loan payments were suspended for that period. You must resume making loan payments at the end of that period and the loan must be repaid by May 30, 2013 (5 years from the date of the loan plus the period of suspension).

If you transfer without full and adequate consideration an annuity contract issued after April 22, 1987, you are treated as receiving a nonperiodic distribution. The distribution equals the excess of:

This rule does not apply to transfers between spouses or transfers incident to a divorce.

If you transfer a full or partial interest in a tax-sheltered annuity that is not subject to restrictions on early distributions to another tax-sheltered annuity, the transfer qualifies for nonrecognition of gain or loss.

If you exchange an annuity contract issued by a life insurance company that is subject to a rehabilitation, conservatorship, or similar state proceeding for an annuity contract issued by another life insurance company, the exchange qualifies for nonrecognition of gain or loss. The exchange is tax free even if the new contract is funded by two or more payments from the old annuity contract. This also applies to an exchange of a life insurance contract for a life insurance, endowment, or annuity contract.

If you transfer part of the cash surrender value of an existing annuity contract for a new annuity contract issued by another insurance company, the transfer qualifies for nonrecognition of gain or loss. The funds must be transferred directly between the insurance companies. Your investment in the original contract immediately before the exchange is allocated between the contracts based on the percentage of the cash surrender value allocated to each contract.

A lump-sum distribution is the distribution or payment in 1 tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). A distribution from a nonqualified plan (such as a privately purchased commercial annuity or a section 457 deferred compensation plan of a state or local government or tax-exempt organization) cannot qualify as a lump-sum distribution.

The participant's entire balance from a plan does not include certain forfeited amounts. It also does not include any deductible voluntary employee contributions allowed by the plan after 1981 and before 1987.

If you receive a lump-sum distribution from a qualified employee plan or qualified employee annuity and the plan participant was born before January 2, 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, discussed later, to figure tax on the ordinary income part.

Each individual, estate, or trust who receives part of a lump-sum distribution on behalf of a plan participant who was born before January 2, 1936, can choose whether to elect the optional methods for the part each received. However, if two or more trusts receive the distribution, the plan participant or the personal representative of a deceased participant must make the choice.

Use Form 4972 to figure the separate tax on a lump-sum distribution using the optional methods. The tax figured on Form 4972 is added to the regular tax figured on your other income. This may result in a smaller tax than you would pay by including the taxable amount of the distribution as ordinary income in figuring your regular tax.

Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income. It does not apply to any part of a distribution that is tax free, such as amounts that represent a return of your cost or that were rolled over to another retirement plan. It also does not apply to corrective distributions of excess deferrals, excess contributions, or excess aggregate contributions (discussed earlier under Taxation of Nonperiodic Payments).

For this purpose, a qualified retirement plan is:

Exceptions to tax.    Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution code “2,” “3,” or “4” should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329. If an exception applies but distribution code “1” (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions.

  

If distribution code “1” is incorrectly shown on your Form 1099-R for a distribution received when you were age 59½ or older, include that distribution on Form 5329. Enter exception number “12” on line 2.

Qualified reservist distributions.   A qualified reservist distribution is not subject to the additional tax on early distributions. A qualified reservist distribution is a distribution (a) from elective deferrals under a section 401(k) or 403(b) plan, or a similar arrangement, (b) to an individual ordered or called to active duty (because he or she is a member of a reserve component) for a period of more than 179 days or for an indefinite period, and (c) made during the period beginning on the date of the order or call and ending at the close of the active duty period. You must be ordered or called to active duty after September 11, 2001, and before December 31, 2007.

  If you received a qualified reservist distribution before 2006 and paid the 10% additional tax, you can claim a refund of that tax by filing Form 1040X to amend your return for the year in which you received the qualified reservist distribution. You have until August 16, 2007, to claim any refund or tax credit that would otherwise be barred by a statute of limitations. Write “active duty reservist” at the top of the form and show the date that you were called to active duty, the amount of the qualified distribution, and the amount of the10% additional tax paid in Part II.

  

You can choose to re-contribute part or all of the distributions to an IRA. Generally, these additional contributions must be made within 2 years after your active-duty period ends. However, if your active duty period ended before August 17, 2006, you will have until August 17, 2008, to make these special contributions. You cannot take a deduction for these contributions. However, the normal dollar limitations for contributions to IRAs do not apply to these special contributions, and you can make regular contributions to your IRA, up to the amount otherwise allowable.

Substantially equal periodic payments.   Payments are substantially equal periodic payments if they are made in accordance with one of the following methods.

1. Required minimum distribution method. Under this method, the resulting annual payment is redetermined each year.

2. Fixed amortization method. Under this method, the resulting annual payment is determined for the first distribution year and remains the same amount for each succeeding year.

3. Fixed annuitization method. Under this method, the resulting annual payment is determined for the first distribution year and remains the same amount for each succeeding year.

For information on these methods, see Revenue Ruling 2002-62, which is on page 710 of Internal Revenue Bulletin 2002-42 at www.irs.gov/pub/irs-irbs/irb02-42.pdf.

  

A change from method (2) or (3) to method (1) is not treated as a modification to which the recapture tax (discussed next) applies.

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 your required beginning date (defined later). The payments each year cannot be less than the minimum required distribution.

If the actual distributions to you in any year are less than the minimum required distribution for that year, you are subject to an additional tax. The tax equals 50% of the part of the required minimum distribution that was not distributed.

For this purpose, a qualified retirement plan includes:

If you receive a qualified hurricane distribution, you must include it in your income in equal amounts over 3 years. For example, if you received a $60,000 qualified hurricane distribution in 2006, you would include $20,000 in your income in 2006, 2007, and 2008. However, you can elect to include the entire distribution in your income in the year it was received.

A qualified hurricane distribution is any distribution you received from an eligible retirement plan if all of the following conditions apply.

If you meet all these conditions, you can generally designate any distribution (including periodic payments and required minimum distributions) from an eligible retirement plan as a qualified hurricane distribution, regardless of whether the distribution was made on account of Hurricane Katrina, Rita, or Wilma. Qualified hurricane distributions are permitted without regard to your need or the actual amount of your economic loss.

A reduction or offset (after August 24, 2005, for Katrina; after September 22, 2005, for Rita; or after October 22, 2005, for Wilma) of your account balance in an eligible retirement plan to repay a loan can also be designated as a qualified hurricane distribution.

If you received a distribution to purchase or construct a main home in the Hurricane Katrina, Rita, or Wilma disaster area, but that home was not purchased or constructed because of Hurricane Katrina, Rita, or Wilma, you can repay that distribution if all of the following apply.

For this purpose, an eligible retirement plan is any plan, annuity, or IRA to which a qualified rollover can be made. A repayment to an IRA is not considered a qualified rollover for purposes of the one-rollover-per-year limitation for IRAs.

A qualified distribution (or any portion thereof) not repaid before March 1, 2006, may be taxable for 2005 and subject to the 10% additional tax on early distributions. However, you may be able to designate a qualified distribution as a qualified hurricane distribution, subject to the rules discussed earlier, if all of the following apply.

If your main home was in the Hurricane Katrina, Rita, or Wilma disaster area and you suffered an economic loss because of the relevant hurricane, the $50,000 maximum limit for distributions treated as loans from employer plans is increased to $100,000. In addition, any payments on new or existing loans from employer plans due before January 1, 2007, may be suspended for one year by the plan administrator. For more information on plan loans, see Loans Treated as Distributions, earlier. To qualify for these provisions, your main home had to be in the disaster area on the following date.