What Is the General Rule for Pensions & Annuities in Pub 939?

IRS Publication 939, “General Rule for Pensions and Annuities,” guides taxpayers in determining the tax implications of their retirement income. It helps calculate what portion of a pension or annuity payment is a tax-free return of investment and what portion is taxable income, as each payment is composed of these two parts. The IRS outlines two calculation methods: the General Rule and the Simplified Method. The General Rule calculates the tax-free portion based on a ratio of the taxpayer’s total investment to the total expected return, and understanding which method applies is the first step.

Determining Which Rule to Use

The choice between the General Rule and the Simplified Method is dictated by IRS regulations. The appropriate method depends on the type of retirement plan and the annuity starting date.

A taxpayer must use the General Rule for payments from a nonqualified plan. These plans include private annuities, commercial annuities, and nonqualified employee plans. For these plans, the General Rule is the only acceptable method.

The rules are date-sensitive for qualified plans, such as 401(k)s, qualified employee annuities, and tax-sheltered annuity (TSA) plans. If the annuity starting date from a qualified plan is after November 18, 1996, the taxpayer must use the Simplified Method, detailed in Publication 575. An exception exists: if the annuity starting date is after this date, but the annuitant was age 75 or older and the payments are guaranteed for at least five years, the General Rule must be used.

If the annuity starting date from a qualified plan was before November 19, 1996, the taxpayer may have had the option to choose between the methods. That choice, once made, was irrevocable. If no choice was made or if the taxpayer did not qualify for the Simplified Method, they would use the General Rule. Taxpayers with older annuities from qualified plans may therefore find themselves required to use the General Rule.

Information Needed for the General Rule Calculation

To perform the General Rule calculation, a taxpayer must gather specific information from their annuity contract and plan documents. This requires looking beyond the gross distribution on Form 1099-R into the annuity’s history and structure.

The first figure is the “investment in the contract,” which is the total cost the taxpayer can recover tax-free. This amount is the sum of all after-tax funds contributed, including premiums and other payments made with money that has already been taxed. It also includes any employer contributions that were required to be included in the employee’s taxable income. Any premiums refunded, rebates, or dividends received on or before the annuity starting date must be subtracted from this total.

The “annuity starting date” is also needed. This is the first day of the first period for which an amount is received as an annuity; for example, if payments are monthly and the first is for January, the annuity starting date is January 1st. This date locks in factors like age for life expectancy calculations.

A taxpayer must also determine the “expected return,” which is the total amount the annuitant can expect to receive. For a fixed-period annuity, the expected return is the payment amount multiplied by the number of payments. For a lifetime annuity, it is calculated by multiplying the annual payment by a life expectancy multiple from the actuarial tables in Publication 939.

Finally, the calculation requires the annuitant’s details, including their age as of the birthday nearest to the annuity starting date. For joint and survivor annuities, the ages of both annuitants are needed to locate the correct life expectancy multiple in the IRS actuarial tables.

Calculating the Taxable Portion Under the General Rule

With this information, the taxpayer can calculate the taxable portion of their annuity payments. The General Rule uses an exclusion ratio to establish the percentage of each payment that is a tax-free return of investment. This ratio remains the same for all payments.

The first step is calculating the exclusion ratio. The formula is the Investment in the Contract divided by the Expected Return. For example, if the investment in the contract is $50,000 and the calculated expected return is $200,000, the exclusion ratio would be 25% ($50,000 ÷ $200,000). This percentage is the portion of each payment that will be excluded from gross income.

The second step is finding the annual tax-free portion by applying the exclusion ratio to the total payments received during the year. Using the previous example, if the taxpayer receives $10,000 in payments during the year, the tax-free portion is $2,500 ($10,000 x 25%).

The third step is determining the taxable amount for the year by subtracting the tax-free portion from the total payment received. In the example, the taxable amount would be $7,500 ($10,000 – $2,500). This amount is reported as taxable income on the taxpayer’s Form 1040.

Using the actuarial tables in Publication 939 is part of finding the expected return for a lifetime annuity. For a single-life annuity, one would use Table V. For example, a person who is 65 on their annuity starting date has a multiple of 20.0, and if their annual annuity payment is $12,000, their expected return would be $240,000 ($12,000 x 20.0).

Special Considerations for the General Rule

Several situations can affect how the General Rule is applied. These considerations address cost recovery limits, the death of an annuitant, and variable annuities.

A taxpayer cannot exclude more than their total investment in the contract. Once the cumulative tax-free portions equal the total investment, all subsequent payments are fully taxable, and the exclusion ratio no longer applies. For example, if the investment was $50,000, once the taxpayer has excluded a cumulative $50,000, all future payments are fully taxable.

If an annuitant dies before recovering their full investment, a rule applies to the unrecovered amount. The miscellaneous itemized deduction for unrecovered investment in an annuity contract is suspended for tax years through 2025. This deduction is scheduled to be available again for tax years after 2025.

The calculation differs for variable annuities, where payments fluctuate based on investment performance. Instead of an exclusion ratio, the tax-free amount is a set dollar figure for each payment, determined by dividing the investment in the contract by the total number of payments expected. For example, if the investment is $120,000 and the life expectancy is 240 monthly payments, $500 of each monthly payment is tax-free. If a payment is more than $500, the excess is taxable; if a payment is less than $500, the shortfall can be accounted for in future years.