Pension & Annuity Income Tax Guide

Is Your Pension or Annuity Taxable?

Pension and annuity payments are taxed as ordinary income, the same as wages, at whatever federal bracket your total income lands in. The only part that escapes tax is a return of money you already paid tax on. So the real question is not whether your pension is taxable but how much of it is, and the answer turns on whether you have a cost in the plan.

If your entire pension was funded with pre-tax dollars (typical of a traditional employer pension where contributions came out before tax, or where the employer paid the whole cost), every dollar you receive is taxable. If you contributed after-tax money along the way, that money was already taxed once, and the law lets you recover it tax-free over the life of the payments. Designated Roth account distributions that are qualified are an exception: they are entirely tax-free.

This guide covers periodic payments, meaning amounts paid at regular intervals over more than one year (monthly or yearly for life or a set term). One-time lump-sum payouts follow different nonperiodic rules and are not the focus here.

Fully Taxable vs Partly Taxable Payments

The IRS splits pensions into two buckets. Your payments are fully taxable if you have no cost in the contract, which happens when you did not contribute any after-tax amounts, your employer did not withhold after-tax contributions, or you already recovered all of your after-tax contributions tax-free in earlier years. In that case you report the full amount on Form 1040 line 5b and nothing is excluded.

Your payments are partly taxable if you contributed after-tax dollars. Then a portion of every payment is a tax-free return of that cost and the remainder is taxable. You figure the tax-free portion once, at the start, using one of two methods: the Simplified Method or the General Rule. Which one applies depends on the type of plan.

The Simplified Method

The Simplified Method is the worksheet most retirees use, because it covers payments from a qualified employer plan, a qualified employee annuity, or a 403(b) plan when the annuity starting date is after November 18, 1996. It is deliberately mechanical: you divide your cost by a fixed number of expected payments, and that gives the tax-free amount in every check.

The Number of Expected Payments

For a single-life annuity, you read the number from IRS Table 1 using your age at the annuity starting date. For a joint and survivor annuity with a starting date after 1997, you use Table 2 and the combined ages of both annuitants.

The Calculation

Take a retiree, age 65, with a $26,000 cost on a single-life pension paying $2,000 a month. Table 1 gives 260 payments. The tax-free part of each payment is $26,000 divided by 260, which is $100. So $100 of every $2,000 payment is a tax-free return of cost, and $1,900 is taxable. Over a full year of $24,000, the taxable amount on line 5b is $22,800. The Pension & Annuity Tax Calculator runs this worksheet for any age, cost, and payment.

The General Rule

The General Rule applies to nonqualified plans, which most often means a commercial annuity you bought from an insurance company, a private annuity, or a nonqualified employee plan. Instead of a fixed payment count from a table, the General Rule uses an exclusion ratio: your cost divided by the total expected return over the life of the annuity, computed with IRS actuarial life expectancy tables.

The exclusion ratio is multiplied by each payment to find the tax-free part. Because the expected return relies on actuarial tables that the IRS publishes, the General Rule is more involved than the Simplified Method, and the IRS will even compute it for you for a fee. The full tables and instructions are in Publication 939. If your annuity is a qualified employer plan, you generally cannot use the General Rule; if it is nonqualified, you generally must.

Your Cost in the Plan

Your cost, also called your investment in the contract or your basis, is the total after-tax money you put into the plan. This includes after-tax contributions you made and any employer contributions that were taxable to you when they were made. It does not include pre-tax salary deferrals, because that money was never taxed and will be taxed when paid out.

From your total contributions you subtract any amounts you already received tax-free, such as refunded contributions or a tax-free single-sum payment received at the start of the annuity. For an annuity whose periodic payments began this year, the payer reports your cost in box 9b of Form 1099-R. Save that figure: it drives the tax-free recovery for the entire life of the annuity, and reconstructing it years later is difficult.

Recovering Your Cost (and the Cap)

Two features of cost recovery surprise people. First, the tax-free amount is fixed in dollars. It is set the year your annuity starts and never changes, even when your pension gets a cost-of-living increase. As the payment grows while the tax-free piece stays flat, a larger share of each check becomes taxable over time.

Second, for an annuity starting after 1986, the total you can exclude is limited to your cost. Once the tax-free portions you have received add up to your full cost, which happens after the number of expected payments, every later payment is fully taxable. In the $26,000 example at $100 a month, the cost is fully recovered after 260 payments (about 21.7 years), and from then on the entire payment is taxable.

There is a matching rule for an early death. If you (and any survivor annuitant) die before recovering the full cost, the unrecovered amount is allowed as a miscellaneous itemized deduction on the final income tax return of the last to die, and it is not subject to the 2 percent floor. That deduction prevents the after-tax money from being taxed twice.

Reading Form 1099-R

Every pension or annuity payer sends Form 1099-R after year end. A few boxes drive everything:

• Box 1 - Gross distribution. The total amount paid to you. This goes on Form 1040 line 5a.
• Box 2a - Taxable amount. The taxable part, if the payer figured it. This goes on line 5b. It is often blank for older pensions.
• Box 2b - Taxable amount not determined. If checked, the payer did not compute the taxable amount and you must use the Simplified Method or General Rule yourself.
• Box 5 - After-tax contributions recovered this year. Sometimes shows the tax-free portion the payer applied.
• Box 7 - Distribution code. Code 7 is a normal distribution; code 1 flags an early distribution that may carry the 10 percent additional tax.
• Box 9b - Total employee contributions. Your cost in the plan, shown in the first year of periodic payments.

The trap is treating box 1 as the taxable number when box 2a is blank. If you do, you overpay every year by failing to claim the tax-free recovery of your own cost. When box 2a is empty or box 2b is checked, do the worksheet.

Withholding with Form W-4P

The taxable part of a pension or annuity is subject to federal income tax withholding, just like wages. You control the amount with Form W-4P, the withholding certificate for periodic pension and annuity payments. You can generally elect to have no tax withheld on periodic payments, but that choice puts the burden on you to pay through estimated taxes instead.

If you give no W-4P and no Social Security number, the payer must withhold as if you were single with no adjustments. Most retirees do the opposite: they set withholding high enough that the pension covers not only its own tax but also the tax on other income, such as the taxable part of Social Security, so they avoid a surprise bill and an underpayment penalty in April.

Pensions and Social Security

A pension does more than add its own taxable income; it can pull more of your Social Security into tax. Social Security taxability is based on provisional income, which includes your taxable pension. As the taxable part of your pension rises, your provisional income rises, and a larger share of your Social Security benefits, up to 85 percent, can become taxable.

This interaction is why a single dollar of extra taxable pension income can cost more than its face bracket would suggest, an effect sometimes called the tax torpedo. Before you set pension withholding or decide whether to take an annuity option with a survivor benefit, model the combined picture with the Social Security Tax Calculator and read Is Social Security Taxable.

Practitioner Insight (LMN Tax Inc.)

Real-World Scenarios

When the Rules Differ

• Nonqualified and commercial annuities. These use the General Rule and an exclusion ratio from actuarial tables (Pub 939), not the Simplified Method.
• Annuity start dates before Nov 19, 1996. Older annuities may use the General Rule or an older table; start dates before 1987 follow pre-1987 exclusion rules with no lifetime cap.
• Joint annuities starting before 1998. A multiple-life annuity beginning before 1998 uses Table 1 and the primary annuitant's age, not the combined-age Table 2.
• Disability pensions before minimum retirement age. These are reported as wages on line 1h until you reach minimum retirement age, then switch to pension treatment.
• Public safety officer insurance exclusion. Eligible retired public safety officers can exclude up to $3,000 of distributions used for health or long-term care insurance premiums.
• Designated Roth accounts. Qualified distributions from a designated Roth 401(k) or 403(b) are entirely tax-free and are not figured under these methods.
• Lump-sum distributions. A single payout is nonperiodic; those born before January 2, 1936, may qualify for the special 10-year tax option or capital gain treatment.

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