Publication 939: Taxing Pensions and Annuities

IRS Publication 939 explains how to determine the tax treatment of pension and annuity income. Payments are divided into two parts: a tax-free return of your net cost (the after-tax money you invested) and a taxable balance of earnings and employer contributions. This publication details the two methods for calculating the taxable portion of each payment: the General Rule and the Simplified Method. The method you must use depends on the type of retirement plan and your annuity starting date.

Determining Your Cost in the Contract

Before you can calculate the taxable portion of your payments, you must determine your cost in the contract. This figure represents the total amount of after-tax money you contributed, which you are allowed to recover tax-free. Any amount you receive beyond your cost is considered taxable income.

To find your cost, review plan statements from your pension or annuity administrator or your past Form W-2s. If you cannot locate this information, contacting your plan administrator or the insurance company is a necessary step.

An accurate cost figure is important for all tax calculations, as it is the starting point for both the General Rule and the Simplified Method worksheet. An incorrect cost basis will lead to an incorrect calculation of your tax-free income, so careful verification of your contributions is needed.

The General Rule for Taxing Annuities

The General Rule is a method used to figure the tax-free portion of each annuity payment based on a ratio of your investment to the total expected return. This method is most often required for distributions from nonqualified plans, such as commercial annuities, and may apply to certain qualified plans if the annuity starting date was before November 19, 1996.

The first step is to calculate the expected return from the contract using IRS actuarial tables from Publication 939. These tables use your life expectancy to project the total amount you are expected to receive.

Once you have the expected return, you calculate the exclusion ratio by dividing your cost in the contract by the total expected return. The resulting percentage is the portion of each payment that is a tax-free return of your cost. For example, if your cost was $20,000 and your expected return is $100,000, your exclusion ratio is 20%.

This exclusion ratio is then applied to every payment you receive. If, in the previous example, your monthly payment is $500, you would multiply that by the 20% exclusion ratio. This means $100 of each payment is tax-free, and the remaining $400 is taxable income.

The Simplified Method

The Simplified Method is a more straightforward approach for calculating the tax-free portion of pension and annuity payments. Its use is required for distributions from qualified retirement plans like 401(k)s and 403(b)s if your annuity starting date was after November 18, 1996. This method uses a worksheet found in IRS Publication 575, Pension and Annuity Income, and avoids the use of actuarial tables.

To use this method, you first locate your cost in the contract. You then find the total number of expected monthly payments from a table in the worksheet. This table is based on your age at the annuity’s starting date.

The calculation itself is a simple division. You divide your total cost in the contract by the number of expected monthly payments you found in the table. The result is the portion of your monthly payment that you can exclude from your income as a tax-free return of your investment.

For instance, if your cost is $60,000 and the table indicates 300 expected monthly payments, your tax-free amount per month would be $200. If your monthly annuity payment is $1,500, you would report $1,300 ($1,500 – $200) as taxable income each month.

Reporting Pension and Annuity Income

After calculating the taxable portion of your income, you must report it on your federal income tax return. You will receive Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

Box 1 of this form shows the gross distribution, which is the total amount you received during the year. Box 2a shows the taxable amount as calculated by the payer, though sometimes Box 2b will be checked, indicating the taxable amount has not been determined.

You will use the information from Form 1099-R to complete your Form 1040. The gross distribution from Box 1 is reported on the line for pensions and annuities, and on a separate line, you report the taxable amount that you calculated. While the payer may provide a taxable amount in Box 2a, you are responsible for ensuring its accuracy.