Annuity Method for Calculating Taxable Payments

An annuity provides a stream of payments, and the annuity method is the tax accounting process for determining the taxable amount of each payment. A payment consists of two parts: a non-taxable return of your original investment and taxable earnings. The goal is to separate your principal from the gains as you receive them over time. The specific calculations vary depending on the type of annuity and how it was funded.

The General Rule for Non-Qualified Annuities

The General Rule is the IRS method for calculating taxable payments from a non-qualified annuity, which is purchased with after-tax dollars. Because the contributions were not tax-deductible, only the earnings portion of each payment is subject to income tax.

Applying this rule requires calculating an exclusion ratio. You will need two figures: your “investment in the contract” and the “expected return.” The investment in the contract is the annuity’s net cost, meaning the total premiums paid less any prior tax-free withdrawals. The expected return is the total amount you anticipate receiving.

For a lifetime annuity, calculate the expected return using life expectancy tables from IRS Publication 939. You find the multiple for your age and multiply it by your annual payment. To get the exclusion ratio, divide the investment by the expected return. This ratio is the percentage of each payment considered a tax-free return of principal.

For example, assume your investment in the contract is $60,000 and your expected return, based on IRS tables, is $100,000. Your exclusion ratio would be 60% ($60,000 / $100,000). If your annuity pays you $5,000 per year, you would multiply that payment by 60% to find the non-taxable portion, which is $3,000. The remaining $2,000 of that annual payment would be reported as taxable income.

The Simplified Method for Qualified Plan Annuities

The Simplified Method is required for calculating the taxable portion of annuity payments from qualified retirement plans, such as 401(k)s and 403(b)s. You must use this method if you meet certain age and guarantee period conditions.

The process uses the Simplified Method Worksheet, found in the instructions for Form 1040 and IRS Publication 575. For the worksheet, you need your cost in the contract, which for a qualified plan is any after-tax contributions you made. If your plan was funded entirely with pre-tax money, your cost is zero, and all payments are fully taxable.

If you have after-tax contributions, the worksheet helps determine the tax-free part of each monthly payment. A table provides the “number of expected monthly payments” based on your age. You divide your cost in the contract by this number to find the tax-free portion of each monthly payment.

For instance, if your cost in the contract is $12,000 and the table indicates 240 expected payments, you would divide $12,000 by 240. The result is $50, which is the tax-free amount of each monthly payment. Any amount received above this is taxable.

The Annuity Method for SEPP Distributions

The annuity concept is also used to calculate Substantially Equal Periodic Payments (SEPP). SEPP allows for distributions from a retirement account like an IRA or 401(k) before age 59½ without the 10% early withdrawal penalty. Permitted under IRS Rule 72(t), the annuity method is one of three approved ways to calculate these payments.

Unlike the other methods, the goal here is not to separate taxable and non-taxable portions of a payment. Instead, the annuity method determines the precise annual withdrawal amount you must take from the account.

The calculation involves dividing your retirement account balance by an annuity factor, which is derived from an IRS mortality table and a specified interest rate. This factor represents the present value of a $1 per year annuity for a person of your age.

Once calculated, the annual payment amount remains fixed for the duration of the SEPP plan. The plan must continue for at least five years or until you reach age 59½, whichever is longer.

Reporting Annuity Income

You must report the taxable portion of your annuity payments on your tax return. The financial institution paying the annuity will send you Form 1099-R, which provides the necessary details for your filing.

On Form 1099-R, Box 1 shows the gross distribution, and Box 2a shows the taxable amount as determined by the payer. If Box 2b is checked, the taxable amount was not determined, and you are responsible for calculating it using the appropriate method.

These figures are reported on Form 1040. The gross distribution from Box 1 of the 1099-R is entered on line 5a, and the taxable amount is entered on line 5b. If federal income tax was withheld, as shown in Box 4, you must attach a copy of Form 1099-R to your return.