Simplified General Rule: How to Calculate Pension Taxes

The Internal Revenue Service (IRS) offers the Simplified General Rule to calculate the tax-free portion of pension or annuity payments. This method ensures that retirees can recover their after-tax contributions, which is their investment in the plan, without paying income tax on that amount. Using this rule helps in accurately reporting income from certain retirement plans and avoiding overpayment of taxes.

Eligibility for the Simplified General Rule

To use the Simplified General Rule, payments must come from a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity contract, often referred to as a 403(b) plan. This rule does not apply to nonqualified plans. If your plan is eligible, you must also meet two additional IRS conditions.

First, your annuity starting date, which is the first day of the first period you receive a payment, must be after November 18, 1996. If your payments began on or before this date, you must use the General Rule unless you were already using the Simplified Method on a previous tax return.

Second, on your annuity starting date, you must meet one of two criteria: you were under age 75, or you were entitled to fewer than five years of guaranteed payments. Guaranteed payments are a set number of payments made regardless of whether the annuitant dies. You cannot use this method if you were 75 or older and entitled to five or more years of guaranteed payments.

Information Required for the Calculation

To perform the calculation, you need your “cost in the contract.” This figure is your net investment in the pension plan, representing the total of any after-tax contributions you made over the years. This is the amount you are allowed to receive back without paying income tax.

You can find your cost in the contract on the Form 1099-R that your plan administrator sends you each year, where it is shown in Box 9b. If this box is blank or you suspect the amount is incorrect, you should contact your plan administrator. They are responsible for maintaining these records and can provide a breakdown of your total investment.

You also need the age of the annuitant or annuitants at the annuity starting date. If the pension is for a single life, you will need your age on the date your payments began. For a joint-and-survivor annuity, which provides payments for you and a beneficiary after your death, you will need the ages of both individuals on that date.

Calculating the Tax-Free Portion of Payments

The Simplified Method Worksheet, found in IRS Publication 575, “Pension and Annuity Income,” guides you through the calculation steps.

The first step is to find the total number of expected monthly payments from the tables in Publication 575. The number depends on whether you have a single-life or a joint-and-survivor annuity. For a single-life annuity, the table uses your age at the annuity start date; for example, if your age was between 61 and 65, the number of expected payments is 260. For a joint-and-survivor annuity, a different table uses the combined ages of both annuitants; for instance, if the combined ages were 121 to 130, the number of expected payments is 310.

Next, divide your cost in the contract by the total number of expected payments. The result is the tax-free portion of each monthly pension payment. To determine your tax-free income for the entire year, you multiply this monthly tax-free amount by the number of payments you received during that tax year.

The final step is to calculate your taxable pension income by subtracting the total tax-free amount for the year from the total pension payments you received. For example, if your cost in the contract is $30,000 and your expected number of payments is 300, your monthly tax-free portion is $100. If you received 12 payments during the year, your total tax-free income is $1,200, and if your total pension was $18,000, your taxable amount would be $16,800.

Reporting and Long-Term Considerations

You must report the amounts correctly on your federal income tax return. The total gross distribution from your pension, found in Box 1 of your Form 1099-R, is reported on line 5a of Form 1040. The taxable portion that you calculated is reported on line 5b.

You must track your recovered cost over the years. You can exclude a portion of your pension from tax only until you have recovered your entire cost in the contract. Once the cumulative tax-free portions you have received equal your total cost, all subsequent pension payments you receive will be fully taxable.

A different rule applies if the annuitant, and any survivor annuitant, passes away before the full cost in the contract has been recovered. In this situation, the unrecovered cost can be claimed as a deduction on the final income tax return of the decedent. This is treated as a miscellaneous itemized deduction and is not subject to the 2% of adjusted gross income (AGI) limit.