Taxation of Periodic Payments

This section explains how the periodic payments you receive under a pension or annuity plan are taxed under the General Rule. Periodic payments are amounts paid at regular intervals (such as weekly, monthly, or yearly) for a period of time greater than one year (such as for 15 years or for life). These payments are also known as amounts received as an annuity.

If you receive an amount from your plan that is a nonperiodic payment (amount not received as an annuity), see Taxation of Nonperiodic Payments in Publication 575. This discussion also covers loans from nonqualified plans and certain transfers of annuity contracts.

In general, you can recover your net cost of the pension or annuity tax free over the period you are to receive the payments. The amount of each payment that is more than the part that represents your net cost is taxable. Under the General Rule, the part of each annuity payment that represents your net cost is in the same proportion that your investment in the contract is to your expected return. These terms are explained in the following discussions.

Investment in the Contract

In figuring how much of your pension or annuity is taxable under the General Rule, you must figure your investment in the contract.

First, find your net cost of the contract as of the annuity starting date (defined later). To find this amount, you must first figure the total premiums, contributions, or other amounts paid. This includes the amounts your employer contributed if you were required to include these amounts in income. It also includes amounts you actually contributed (except amounts for health and accident benefits and deductible voluntary employee contributions).

From this total cost you subtract:

1. Any refunded premiums, rebates, dividends, or unrepaid loans (any of which were not included in your income) that you received by the later of the annuity starting date or the date on which you received your first payment.
2. Any additional premiums paid for double indemnity or disability benefits.
3. Any other tax-free amounts you received under the contract or plan before the later of the dates in (1).

The annuity starting date is either the later of the first day of the first period for which you receive payment under the contract or the date on which the obligation under the contract becomes fixed, whichever comes later.

Example. On January 1 you completed all your payments required under an annuity contract providing for monthly payments starting on August 1, for the period beginning July 1. The annuity starting date is July 1. This is the date you use in figuring your investment in the contract and your expected return (discussed later).

Adjustments

If any of the following items apply, adjust (add or subtract) your total cost to find your net cost.

Foreign employment. If you worked abroad before 1963, your cost includes amounts contributed by your employer that were not includible in your gross income. The contributions that apply were made either:

1. Before 1963 by your employer for that work, or
2. After 1962 by your employer for that work if you performed the services under a plan that existed on March 12, 1962.

Death benefit exclusion. If you are the beneficiary of a deceased employee (or former employee), who died before August 21, 1996, you may qualify for a death benefit exclusion of up to $5,000.

New law repealed this exclusion from income if you are the beneficiary of an employee who died after August 20, 1996.

How to adjust your total cost. If you are eligible, treat the amount of any allowable death benefit exclusion as additional cost paid by the employee. Add it to the cost or unrecovered cost of the annuity at the annuity starting date. See Example 3 under Computation Under General Rule for an illustration of the adjustment to the cost of the contract.

Free IRS help. If you are eligible for this exclusion and need help computing the amount of the death benefit exclusion, see Requesting a Ruling on Taxation of Annuity, near the end of this publication.

Net cost. The amount you have figured so far, the total cost plus certain adjustments and minus other amounts already recovered before the annuity starting date, is the net cost. This is the unrecovered investment in the contract as of the annuity starting date. If your annuity starting date is after 1986, this is the maximum amount that you may recover tax free under the contract.

Refund feature. Adjustment for the value of the refund feature is only applicable when you report your pension or annuity under the General Rule. Your annuity contract has a refund feature if:

1. The expected return (discussed later) of an annuity depends entirely or partly on the life of one or more persons,
2. The contract provides that payments will be made to a beneficiary or the estate of an annuitant on or after the death of the annuitant if a stated amount or a stated number of payments has not been paid to the annuitant or annuitants before death, and
3. The payments are a refund of the amount you paid for the annuity contract.

If you are reporting your annuity under the General Rule, and your annuity has a refund feature, you must reduce your net cost of the contract by the value of the refund feature (figured using Table III or VII at the end of this publication--see How to Use Actuarial Tables, later) to find the investment in the contract.

Zero value of refund feature. For a joint and survivor annuity, the value of the refund feature is zero if:

1. Both annuitants are age 74 or younger,
2. The payments are guaranteed for less than 2 1/2 years, and
3. The survivor's annuity is at least 50% of the first annuitant's annuity.

For a single-life annuity without survivor benefit, the value of the refund feature is zero if:

1. The payments are guaranteed for less than 2 1/2 years, and
2. The annuitant is:
   1. Age 57 or younger (if using the new (unisex) annuity tables),
   2. Age 42 or younger (if male and using the old annuity tables), or
   3. Age 47 or younger (if female and using the old annuity tables).

If you do not meet these requirements, you will have to figure the value of the refund feature, as explained in the following discussion.

Examples. The first example shows how to figure the value of the refund feature when there is only one beneficiary. Example 2 shows how to figure the value of the refund feature when the contract provides, in addition to a whole life annuity, one or more temporary life annuities for the lives of children. In both examples, the taxpayer elects to use Tables V through VIII. If you need the value of the refund feature for a joint and survivor annuity, write to the Internal Revenue Service as explained under Requesting a Ruling on Taxation of Annuity, at the end of this publication.

Example 1. At age 65, Barbara Brown bought for $21,053 an annuity with a refund feature. She will get $100 a month for life. Barbara's contract provides that if she does not live long enough to recover the full $21,053, similar payments will be made to her surviving beneficiary until a total of $21,053 has been paid under the contract. In this case, the contract cost and the total guaranteed return are the same ($21,053). Barbara's investment in the contract is figured as follows:

If the total guaranteed return were less than the $21,053 net cost of the contract, Barbara would apply the appropriate percentage from the tables to the lesser amount. For example, if the contract guaranteed the $100 monthly payments for 17 years to Barbara's estate or beneficiary if she were to die before receiving all the payments for that period, the total guaranteed return would be $20,400 ($100 × 12 × 17 years). In this case, the value of the refund feature would be $2,856 (14% of $20,400) and Barbara's investment in the contract would be $18,197 ($21,053 minus $2,856) instead of $17,895.

Example 2. John Chase died while still employed. His widow, Eleanor, age 48, receives $171 a month for the rest of her life. John's son, Elmer, age 9, receives $50 a month until he reaches age 18. John's contributions to the retirement fund totaled $7,559.45, with interest on those contributions of $1,602.53. The guarantee or total refund feature of the contract is $9,161.98 ($7,559.45 plus $1,602.53).

The adjustment in the investment in the contract is figured as follows:

Free IRS help. If you need to request assistance to figure the value of the refund feature, see Requesting a Ruling on Taxation of Annuity, near the end of this publication.

Expected Return

Your expected return is the total amount you and other eligible annuitants can expect to receive under the contract. The following discussions explain how to figure the expected return with each type of annuity.

A person's age, for purposes of figuring the expected return, is the age at the birthday nearest to the annuity starting date.

Fixed period annuity. If you will get annuity payments for a fixed number of years, without regard to your life expectancy, you must figure your expected return based on that fixed number of years. It is the total amount you will get beginning at the annuity starting date. You will receive specific periodic payments for a definite period of time, such as a fixed number of months (but not less than 13). To figure your expected return, multiply the fixed number of months for which payments are to be made by the amount of the payment specified for each period.

Single life annuity. If you are to get annuity payments for the rest of your life, find your expected return as follows. You must multiply the amount of the annual payment by a multiple based on your life expectancy as of the annuity starting date. These multiples are set out in actuarial Tables I and V at the end of this publication (see How To Use Actuarial Tables, later).

You may need to adjust these multiples if the payments are made quarterly, semiannually, or annually. See Adjustments to Tables I, II, V, VI, and VIA following Table I.

Example. Henry Martin bought an annuity contract that will give him an annuity of $500 a month for his life. If at the annuity starting date Henry's nearest birthday is 66, the expected return is figured as follows:

If the payments were to be made to Henry quarterly and the first payment was made one full month after the annuity starting date, Henry would adjust the 19.2 multiple by +.1. His expected return would then be $115,800 ($6,000 × 19.3).

Annuity for shorter of life or specified period. With this type of annuity, you are to get annuity payments either for the rest of your life or until the end of a specified period, whichever period is shorter. To figure your expected return, multiply the amount of your annual payment by a multiple in Table IV or VIII for temporary life annuities. Find the proper multiple based on your sex, your age at the annuity starting date, and the nearest whole number of years in the specified period.

Example. Harriet Brown purchased an annuity this year that will pay her $200 each month for five years or until she dies, whichever period is shorter. She was age 65 at her birthday nearest the annuity starting date. She figures the expected return as follows:

She uses Table VIII (not Table IV) because all her contributions were made after June 30, 1986. See Special Elections, later.

Joint and survivor annuities. If you have an annuity that pays you a periodic income for life and after your death provides an identical lifetime periodic income to your spouse (or some other person), you figure the expected return based on your combined life expectancies. To figure the expected return, multiply the annual payment by a multiple in Table II or VI based on your joint life expectancies. If your payments are made quarterly, semiannually, or annually, you may need to adjust these multiples. See Adjustments to Tables I, II, V, VI, and VIA following Table I at the end of this publication.

Example. John Carter bought a joint and survivor annuity providing payments of $500 a month for his life, and, after his death, $500 a month for the remainder of his wife's life. At John's annuity starting date, his age at his nearest birthday is 70 and his wife's at her nearest birthday is 67. The expected return is figured as follows:

Different payments to survivor. If your contract provides that payments to a survivor annuitant will be different from the amount you receive, you must use a computation which accounts for both the joint lives of the annuitants and the life of the survivor.

Example 1. Gerald Morris bought a contract providing for payments to him of $500 a month for life and, after his death, payments to his wife, Mary, of $350 a month for life. If, at the annuity starting date, Gerald's nearest birthday is 70 and Mary's is 67, the expected return under the contract is figured as follows:

Example 2. Your husband died while still employed. Under the terms of his employer's retirement plan, you are entitled to get an immediate annuity of $400 a month for the rest of your life or until you remarry. Your daughters, Marie and Jean, are each entitled to immediate temporary life annuities of $150 a month until they reach age 18. You elect to use Tables V through VIII.

You were 50 years old at the annuity starting date. Marie was 16 and Jean was 14. Using the multiples shown in Tables V and VIII at the end of this publication, the total expected return on the annuity starting date is $169,680, figured as follows:

No computation of expected return is made based on your husband's age at the date of death because he died before the annuity starting date.

Computation Under General Rule

Under the General Rule, you figure the taxable part of your annuity by using the following steps:

Step 1. Figure the amount of your investment in the contract, including any adjustments for the refund feature and the death benefit exclusion.

This exclusion from income does not apply if you are the beneficiary of an employee who died after August 20, 1996. If you qualify, see how to obtain free IRS help in the discussion of adjustments to your cost of the contract, earlier.

Step 2. Figure your expected return.

Step 3. Divide Step 1 by Step 2 and round to three decimal places. This will give you the exclusion percentage.

Step 4. Multiply the exclusion percentage by the first regular periodic payment. The result is the tax-free part of each pension or annuity payment.

The tax-free part remains the same even if the total payment increases or you outlive the life expectancy factor used. If your annuity starting date is after 1986, the total amount of annuity income that is tax free over the years cannot exceed your net cost.

Each annuitant applies the same exclusion percentage to his or her initial payment called for in the contract.

Step 5. Multiply the tax-free part of each payment (step 4) by the number of payments received during the year. This will give you the tax-free part of the total payment for the year.

In the first year of your annuity, your first payment or part of your first payment may be for a fraction of the payment period. This fractional amount is multiplied by your exclusion percentage to get the tax-free part.

Step 6. Subtract the tax-free part from the total payment you received. The rest is the taxable part of your pension or annuity.

Example 1. You purchased an annuity with an investment in the contract of $10,800. Under its terms, the annuity will pay you $100 a month for life. The multiple for your age (age 65) is 20.0 as shown in Table V. Your expected return is $24,000 (20 × 12 × $100). Your cost of $10,800, divided by your expected return of $24,000, equals 45.0%. This is the percentage you will not have to include in income.

Each year, until your net cost is recovered, $540 (45% of $1,200) will be tax free and you will include $660 ($1,200 - $540) in your income. If you had received only six payments of $100 ($600) during the year, your exclusion would have been $270 (45% of $100 × 6 payments).

Example 2. Gerald Morris bought a joint and survivor annuity. Gerald's investment in the contract is $62,712 and the expected return is $121,200. The exclusion percentage is 51.7% ($62,712 ÷ $121,200). Gerald will receive $500 a month ($6,000 a year). Each year, until his net cost is recovered, $3,102 (51.7% of his total payments received of $6,000) will be tax free and $2,898 ($6,000 - $3,102) will be included in his income. If Gerald dies, his wife will receive $350 a month ($4,200 a year). If Gerald had not recovered all of his net cost before his death, his wife will use the same exclusion percentage (51.7%). Each year, until the entire net cost is recovered, his wife will receive $2,171.40 (51.7% of her payments received of $4,200) tax free. She will include $2,028.60 ($4,200 - $2,171.40) in her income tax return.

Example 3. Using the same facts as Example 2 under Different payments to survivor, you are to receive an annual annuity of $4,800 until you die or remarry. Your two daughters each receive annual annuities of $1,800 until they reach age 18. Your husband contributed $25,576 to the plan. You are eligible for the $5,000 death benefit exclusion because your husband died before August 21, 1996.

The total expected return, as previously figured (in Example 2 under Different payments to survivor), is $169,680. The exclusion percentage of 18.0% ($30,576 ÷ $169,680) applies to the annuity payments you and each of your daughters receive. Each full year $864 (18.0% × $4,800) will be tax free to you, and you must include $3,936 in your income tax return. Each year, until age 18, $324 (18.0% × $1,800) of each of your daughters' payments will be tax free and each must include the balance, $1,476, as income on her own income tax return.

Part-year payments. If you receive payments for only part of a year, apply the exclusion percentage to the first regular periodic payment, and multiply the result by the number of payments received during the year. If you received a fractional payment, follow Step 5, discussed earlier. This gives you the tax-free part of your total payment.

Example. On September 28, Mary Jones bought an annuity contract for $22,050 that will give her $125 a month for life, beginning October 30. The applicable multiple from Table V is 23.3 (age 61). Her expected return is $34,950 ($125 × 12 × 23.3). Mary's investment in the contract of $22,050, divided by her expected return of $34,950, equals 63.1%. Each payment received will consist of 63.1% return of cost and 36.9% taxable income, until her net cost of the contract is fully recovered. During the first year, Mary received three payments of $125, or $375, of which $236.63 (63.1% × $375) is a return of cost. The remaining $138.37 is included in income.

Increase in annuity payments. The tax-free amount remains the same as the amount figured at the annuity starting date, even if the payment increases. All increases in the installment payments are fully taxable.

Example. Joe Smith's wife died on January 1, 1997 while she was still employed and, as her beneficiary, he began receiving an annuity of $147 per month. In figuring the taxable part, Joe elects to use Tables V through VIII. The cost of the contract was $7,938, consisting of the sum of his wife's net contributions, adjusted for any refund feature. His expected return as of the annuity starting date is $35,280 (age 65, multiple of 20.0 × $1,764 annual payment). The exclusion percentage is $7,938 ÷ $35,280, or 22.5%. During the year he received 11 monthly payments of $147, or $1,617. Of this amount, 22.5% × $147 × 11 ($363.83) is tax free as a return of cost and the balance of $1,253.17 is taxable.

Later, because of a cost-of-living increase, his annuity payment was increased to $166 per month, or $1,992 a year (12 × $166). The tax-free part is still only 22.5% of the annuity payments as of the annuity starting date (22.5% × $147 × 12 = $396.90 for a full year). The increase of $228 ($1,992 - $1,764 (12 × $147)) is fully taxable.

Variable annuities. For variable annuity payments, figure the amount of each payment that is tax free by dividing your investment in the contract (adjusted for any refund feature) by the total number of periodic payments you expect to get under the contract.

If the annuity is for a definite period, you determine the total number of payments by multiplying the number of payments to be made each year by the number of years you will receive payments. If the annuity is for life, you determine the total number of payments by using a multiple from the appropriate actuarial table.

Example. Frank Green purchased a variable annuity at age 65. The total cost of the contract was $12,000. The annuity starting date is January 1 of the year of purchase. His annuity will be paid, starting July 1, in variable annual installments for his life. The tax-free amount of each payment, until he has recovered his cost of his contract, is:

If Frank's first payment is $920, he includes only $320 ($920 - $600) in his gross income.

If the tax-free amount for a year is more than the payments you receive in that year, you may choose, when you receive the next payment, to refigure the tax-free part. Divide the amount of the periodic tax-free part that is more than the payment you received by the remaining number of payments you expect. The result is added to the previously figured periodic tax-free part. The sum is the amount of each future payment that will be tax free.

Example. Using the facts of the previous example about Frank Green, assume that after Frank's $920 payment, he received $500 in the following year, and $1,200 in the year after that. Frank does not pay tax on the $500 (second year) payment because $600 of each annual pension payment is tax free. Since the $500 payment is less than the $600 annual tax-free amount, he may choose to refigure his tax-free part when he receives his $1,200 (third year) payment, as follows:

If you choose to refigure your tax-free amount, you must file a statement with your income tax return stating that you are refiguring the tax-free amount in accordance with the rules of section 1.72-4(d)(3) of the Income Tax Regulations. The statement must also show the following information:

1. The annuity starting date and your age on that date.
2. The first day of the first period for which you received an annuity payment in the current year.
3. Your investment in the contract as originally figured.
4. The total of all amounts received tax free under the annuity from the annuity starting date through the first day of the first period for which you received an annuity payment in the current tax year.

Exclusion Limits

Your annuity starting date determines the total amount of annuity income that you can exclude from income over the years.

Exclusion limited to net cost. If your annuity starting date is after 1986, the total amount of annuity income that you can exclude over the years as a return of your cost cannot exceed your net cost (figured without any reduction for a refund feature). This is the unrecovered investment in the contract as of the annuity starting date.

If your annuity starting date is after July 1, 1986, any unrecovered net cost at your (or last annuitant's) death is allowed as a miscellaneous itemized deduction on the final return of the decedent. This deduction is not subject to the 2%-of-adjusted-gross-income limit.

Example 1. Your annuity starting date is after 1986. Your total cost is $12,500, and your net cost is $10,000, taking into account certain adjustments. There is no refund feature. Your monthly annuity payment is $833.33. Your exclusion ratio is 12% and you exclude $100 a month. Your exclusion ends after 100 months, when you have excluded your net cost of $10,000. Thereafter, your annuity payments are fully taxable.

Example 2. The facts are the same as in Example 1, except that there is a refund feature, and you die after 5 years with no surviving annuitant. The adjustment for the refund feature is $1,000, so the investment in the contract is $9,000. The exclusion ratio is 10.8%, and your monthly exclusion is $90. After 5 years (60 months), you have recovered tax free only $5,400 ($90 x 60). An itemized deduction for the unrecovered net cost of $4,600 ($10,000 net cost minus $5,400) may be taken on your final income tax return.

Your unrecovered investment is determined without regard to the refund feature adjustment, discussed earlier.

Exclusion not limited to net cost. If your annuity starting date was before 1987, you could continue to take your monthly exclusion for as long as you receive your annuity. If you choose a joint and survivor annuity, your survivor continues to take the survivor's exclusion figured as of the annuity starting date. The total exclusion may be more than your investment in the contract.