The tax rules in this publication apply both to annuities that provide fixed payments and to annuities that provide payments that vary in amount based on investment results or other factors. For example, they apply to commercial variable annuity contracts, whether bought by an employee retirement plan for its participants or bought directly from the issuer by an individual investor. Under these contracts, the owner can generally allocate the purchase payments among several types of investment portfolios or mutual funds and the contract value is determined by the performance of those investments. The earnings are not taxed until distributed either in a withdrawal or in annuity payments. The taxable part of a distribution is treated as ordinary income.

For information on the tax treatment of a transfer or exchange of a variable annuity contract, see Transfers of Annuity Contracts under Taxation of Nonperiodic Payments, later.

If you work for a state or local government or for a tax-exempt organization, you may be able to participate in a section 457 deferred compensation plan. If your plan is an eligible plan, you are not taxed currently on pay that is deferred under the plan or on any earnings from the plan's investment of the deferred pay. You are taxed on amounts deferred in an eligible state or local government plan only when they are distributed from the plan. You are taxed on amounts deferred in an eligible tax-exempt organization plan when they are distributed or otherwise made available to you.

This publication covers the tax treatment of benefits under eligible section 457 plans, but it does not cover the treatment of deferrals. For information on deferrals under section 457 plans, see Retirement Plan Contributions under Employee Compensation in Publication 525.

If you retired on disability, you generally must include in income any disability pension you receive under a plan that is paid for by your employer. You must report your taxable disability payments as wages on line 7 of Form 1040 or Form 1040A until you reach minimum retirement age . Minimum retirement age generally is the age at which you can first receive a pension or annuity if you are not disabled.

Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on Form 1040, lines 16a and 16b or on Form 1040A, lines 12a and 12b.

Benefits paid under the Railroad Retirement Act fall into two categories. These categories are treated differently for income tax purposes.

The first category is the amount of tier 1 railroad retirement benefits that equals the social security benefit that a railroad employee or beneficiary would have been entitled to receive under the social security system. This part of the tier 1 benefit is the social security equivalent benefit (SSEB) and you treat it for tax purposes like social security benefits. If you received or repaid the SSEB portion of tier 1 benefits during 2004, you will receive Form RRB-1099 , Payments by the Railroad Retirement Board (or Form RRB-1042S , Statement for Nonresident Aliens of Payments by the Railroad Retirement Board, if you are a nonresident alien) from the U.S. Railroad Retirement Board (RRB).

For more information about the tax treatment of the SSEB portion of tier 1 benefits and Forms RRB-1099 and RRB-1042S, see Publication 915.

The second category contains the rest of the tier 1 railroad retirement benefits, called the non-social security equivalent benefit (NSSEB). It also contains any tier 2 benefit, vested dual benefit (VDB), and supplemental annuity benefit. Treat this category of benefits, shown on Form RRB-1099-R, as an amount received from a qualified employee plan. This allows for the tax-free (nontaxable) recovery of employee contributions from the tier 2 benefits and the NSSEB part of the tier 1 benefits. (NSSEB and tier 2 benefits, less certain repayments, are combined into one amount called the Contributory Amount Paid on Form RRB-1099-R.) Vested dual benefits and supplemental annuity benefits are fully taxable. See Taxation of Periodic Payments, later, for information on how to report your benefits and how to recover the employee contributions tax free. Form RRB-1099-R is used for U.S. citizens, resident aliens, and nonresident aliens.

Form RRB-1099-R.   The following discussion explains the items shown on Form RRB-1099-R. The amounts shown on this form are before any deduction for:

• Federal income tax withholding,

• Medicare premiums,

• Legal process garnishment payments,

• Legal process assignment payments,

• Recovery of a prior year overpayment of an NSSEB, tier 2 benefit, VDB, or supplemental annuity benefit, or

• Recovery of Railroad Unemployment Insurance Act benefits received while awaiting payment of your railroad retirement annuity.

  The amounts shown on this form are after any offset for:

• Social Security benefits,

• Age reduction,

• Public Service pensions or public disability benefits,

• Dual railroad retirement entitlement under another RRB claim number,

• Work deductions,

• Legal process partition deductions,

• Actuarial adjustment,

• Annuity waiver, or

• Recovery of a current-year overpayment of NSSEB, tier 2, VDB, or supplemental annuity benefits.

  The amounts shown on Form RRB-1099-R do not reflect any special rules, such as capital gain treatment or the special 10-year tax option for lump-sum payments, or tax-free rollovers. To determine if any of these rules apply to your benefits, see the discussions about them later.

  Generally, amounts shown on your Form RRB-1099-R are considered a normal distribution. Use distribution code “7” if you are asked for a distribution code.

  There are three copies of this form. Copy B is to be included with your income tax return if federal income tax is witheld. Copy C is for your own records. Copy 2 is filed with your state, city, or local income tax return, when required. See the illustrated Copy B (Form RRB-1099-R) above.

  

Each beneficiary will receive his or her own Form RRB-1099-R. If you receive benefits on more than one railroad retirement record, you may get more than one Form RRB-1099-R. So that you get your form timely, make sure the RRB always has your current mailing address.

  

Form RRB–1099–R

Box 3—Employee Contributions.   This is the amount of taxes withheld from the railroad employee's earnings that exceeds the amount of taxes that would have been withheld had the earnings been covered under the social security system. This amount is the employee's cost (investment in the contract) that you use to figure the tax-free part of the NSSEB and tier 2 benefit you received (the amount shown in box 4). (For information on how to figure the tax-free part, see Partly Taxable Payments under Taxation of Periodic Payments, later.) The amount shown is the total employee contributions, not reduced by any amounts that the RRB calculated as previously recovered. It is the latest amount reported for 2004 and may have increased or decreased from a previous Form RRB-1099-R. If this amount has changed, you may need to refigure the tax-free part of your NSSEB/tier 2 benefit. If this box is blank, it means that the amount of your NSSEB and tier 2 payments shown in box 4 is fully taxable.

  

If you had a previous annuity entitlement that ended and you are figuring the tax-free part of your NSSEB/tier 2 benefit for your current annuity entitlement, you should contact the RRB for confirmation of your correct employee contributions amount.

Box 8—Repayments.   This amount represents any NSSEB, tier 2 benefit, VDB, and supplemental annuity benefit you repaid to the RRB in 2004 for years before 2004 or for unknown years. The amount shown in this box has not been deducted from the amounts shown in boxes 4, 5, and 6. It only includes repayments of benefits that were taxable to you. This means it only includes repayments in 2004 of NSSEB benefits paid after 1985, tier 2 and VDB benefits paid after 1983, and supplemental annuity benefits paid in any year. If you included the benefits in your income in the year you received them, you may be able to deduct the repaid amount. For more information about repayments, see Repayment of benefits received in an earlier year, later.

  

You may have repaid an overpayment of benefits by returning a payment, by making a payment, or by having an amount withheld.

Your retirement plan distributions are subject to federal income tax withholding. However, you can choose not to have tax withheld on payments you receive unless they are eligible rollover distributions. If you choose not to have tax withheld or if you do not have enough tax withheld, you may have to make estimated tax payments. See Estimated tax, later.

The withholding rules apply to the taxable part of payments you receive from:

For this purpose, a commercial annuity means an annuity, endowment, or life insurance contract issued by an insurance company.

The pension or annuity payments that you receive are fully taxable if you have no cost in the contract because:

Report the total amount you got on Form 1040, line 16b, or Form 1040A, line 12b. You should make no entry on Form 1040, line 16a, or Form 1040A, line 12a.

If you have a cost to recover from your pension or annuity plan (see Cost (Investment in the Contract), earlier), you can exclude part of each annuity payment from income as a recovery of your cost. This tax-free part of the payment is figured when your annuity starts and remains the same each year, even if the amount of the payment changes. The rest of each payment is taxable.

You figure the tax-free part of the payment using one of the following methods.

You determine which method to use when you first begin receiving your annuity, and you continue using it each year that you recover part of your cost.

Simplified Method

Under the Simplified Method, you figure the tax-free part of each annuity payment by dividing your cost by the total number of anticipated monthly payments. For an annuity that is payable for the lives of the annuitants, this number is based on the annuitants' ages on the annuity starting date and is determined from a table. For any other annuity, this number is the number of monthly annuity payments under the contract.

Who must use the Simplified Method.   You must use the Simplified Method if your annuity starting date is after November 18, 1996, and you meet both of the following conditions.

1. You receive your pension or annuity payments from any of the following plans.

   1. A qualified employee plan.

   2. A qualified employee annuity.

   3. A tax-sheltered annuity plan (403(b) plan).

2. On your annuity starting date, at least one of the following conditions applies to you.

   1. You are under age 75.

   2. You are entitled to less than 5 years of guaranteed payments.

Guaranteed payments.   Your annuity contract provides guaranteed payments if a minimum number of payments or a minimum amount (for example, the amount of your investment) is payable even if you and any survivor annuitant do not live to receive the minimum. If the minimum amount is less than the total amount of the payments you are to receive, barring death, during the first 5 years after payments begin (figured by ignoring any payment increases), you are entitled to less than 5 years of guaranteed payments.

Annuity starting before November 19, 1996.   If your annuity starting date is after July 1, 1986, and before November 19, 1996, and you chose to use the Simplified Method, you must continue to use it each year that you recover part of your cost. You could have chosen to use the Simplified Method if your annuity is payable for your life (or the lives of you and your survivor annuitant) and you met both of the conditions listed earlier for annuities starting after November 18, 1996 (under Who must use the Simplified Method).

Who cannot use the Simplified Method.   You cannot use the Simplified Method if you receive your pension or annuity from a nonqualified plan or otherwise do not meet the conditions described in the preceding discussion. See General Rule, later.

How to use the Simplified Method.    Complete the worksheet in the back of this publication to figure your taxable annuity for 2004. Be sure to keep the completed worksheet; it will help you figure your taxable annuity next year.

  To complete line 3 of the worksheet, you must determine the total number of expected monthly payments for your annuity. How you do this depends on whether the annuity is for a single life, multiple lives, or a fixed period. For this purpose, treat an annuity that is payable over the life of an annuitant as payable for that annuitant's life even if the annuity has a fixed-period feature or also provides a temporary annuity payable to the annuitant's child under age 25.

  

You do not need to complete line 3 of the worksheet or make the computation on line 4 if you received annuity payments last year and used last year's worksheet to figure your taxable annuity. Instead, enter the amount from line 4 of last year's worksheet on line 4 of this year's worksheet.

Single-life annuity.   If your annuity is payable for your life alone, use Table 1 at the bottom of the worksheet to determine the total number of expected monthly payments. Enter on line 3 the number shown for your age on your annuity starting date. This number will differ depending on whether your annuity starting date is before November 19, 1996, or after November 18, 1996.

Multiple-lives annuity.   If your annuity is payable for the lives of more than one annuitant, use Table 2 at the bottom of the worksheet to determine the total number of expected monthly payments. Enter on line 3 the number shown for the annuitants' combined ages on the annuity starting date. For an annuity payable to you as the primary annuitant and to more than one survivor annuitant, combine your age and the age of the youngest survivor annuitant. For an annuity that has no primary annuitant and is payable to you and others as survivor annuitants, combine the ages of the oldest and youngest annuitants. Do not treat as a survivor annuitant anyone whose entitlement to payments depends on an event other than the primary annuitant's death.

  However, if your annuity starting date is before 1998 , do not use Table 2 and do not combine the annuitants' ages. Instead, you must use Table 1 at the bottom of the worksheet and enter on line 3 the number shown for the primary annuitant's age on the annuity starting date. This number will differ depending on whether your annuity starting date is before November 19, 1996, or after November 18, 1996.

Fixed-period annuity.   If your annuity does not depend on anyone's life expectancy, the total number of expected monthly payments to enter on line 3 of the worksheet is the number of monthly annuity payments under the contract.

Example.

Bill Smith, age 65, began receiving retirement benefits in 2004 under a joint and survivor annuity. Bill's annuity starting date is January 1, 2004. The benefits are to be paid for the joint lives of Bill and his wife, Kathy, age 65. Bill had contributed $31,000 to a qualified plan and had received no distributions before the annuity starting date. Bill is to receive a retirement benefit of $1,200 a month, and Kathy is to receive a monthly survivor benefit of $600 upon Bill's death.

Bill must use the Simplified Method to figure his taxable annuity because his payments are from a qualified plan and he is under age 75. Because his annuity is payable over the lives of more than one annuitant, he uses his and Kathy's combined ages and Table 2 at the bottom of the worksheet in completing line 3 of the worksheet. His completed worksheet is shown on the next page.

Bill's tax-free monthly amount is $100 ($31,000 ÷ 310 as shown on line 4 of the worksheet). Upon Bill's death, if Bill has not recovered the full $31,000 investment, Kathy will also exclude $100 from her $600 monthly payment. The full amount of any annuity payments received after 310 payments are paid must be included in gross income.

If Bill and Kathy die before 310 payments are made, a miscellaneous itemized deduction will be allowed for the unrecovered cost on the final income tax return of the last to die. This deduction is not subject to the 2%-of-adjusted gross-income limit.

Worksheet A. Simplified Method Worksheet for Bill Smith (Keep for Your Records)

1.	Enter the total pension or annuity payments received this year. Also, add this amount to the total for Form 1040, line 16a, or Form 1040A, line 12a	1.	$14,400
2.	Enter your cost in the plan (contract) at the annuity starting date	2.	31,000
	Note: If your annuity starting date was before this year and you completed this worksheet last year, skip line 3 and enter the amount from line 4 of last year's worksheet on line 4 below. Otherwise, go to line 3.
3.	Enter the appropriate number from Table 1 below. But if your annuity starting date was after 1997 and the payments are for your life and that of your beneficiary, enter the appropriate number from Table 2 below	3.	310
4.	Divide line 2 by the number on line 3	4.	100
5.	Multiply line 4 by the number of months for which this year's payments were made. If your annuity starting date was before 1987, enter this amount on line 8 below and skip lines 6, 7, 10, and 11. Otherwise, go to line 6	5.	1,200
6.	Enter any amount previously recovered tax free in years after 1986	6.	–0–
7.	Subtract line 6 from line 2	7.	31,000
8.	Enter the smaller of line 5 or line 7	8.	1,200
9.	Taxable amount for year. Subtract line 8 from line 1. Enter the result, but not less than zero. Also, add this amount to the total for Form 1040, line 16b, or Form 1040A, line 12b. Note: If your Form 1099-R shows a larger taxable amount, use the amount on this line instead	9.	$13,200
10.	Add lines 6 and 8	10.	1,200
11.	Balance of cost to be recovered. Subtract line 10 from line 2	11.	$29,800

	TABLE 1 FOR LINE 3 ABOVE
		AND your annuity starting date was—
	IF the age at annuity starting date was...	before November 19, 1996, enter on line 3...	after November 18, 1996, enter on line 3...
	55 or under	300	360
	56–60	260	310
	61–65	240	260
	66–70	170	210
	71 or older	120	160
	TABLE 2 FOR LINE 3 ABOVE
	IF the combined ages at annuity starting date were...		THEN enter on line 3...
	110 or under		410
	111–120		360
	121–130		310
	131–140		260
	141 or older		210

Multiple annuitants.   If you and one or more other annuitants receive payments at the same time, you exclude from each annuity payment a pro rata share of the monthly tax-free amount. Figure your share in the following steps.

1. Complete your worksheet through line 4 to figure the monthly tax-free amount.

2. Divide the amount of your monthly payment by the total amount of the monthly payments to all annuitants.

3. Multiply the amount on line 4 of your worksheet by the amount figured in (2) above. The result is your share of the monthly tax-free amount.

  Replace the amount on line 4 of the worksheet with the result in (3) above. Enter that amount on line 4 of your worksheet each year.

How you figure the taxable amount of a nonperiodic distribution depends on whether it is made before the annuity starting date or on or after the annuity starting date. If it is made before the annuity starting date, its tax treatment also depends on whether it is made under a qualified or nonqualified plan and, if it is made under a nonqualified plan, whether it fully discharges the contract or is allocable to an investment you made before August 14, 1982.

Distributions of employer securities.    If you receive a distribution of employer securities from a qualified retirement plan, you may be able to defer the tax on the net unrealized appreciation (NUA) in the securities. The NUA is the increase in the securities' value while they were in the trust. This tax deferral applies to distributions of the employer corporation's stocks, bonds, registered debentures, and debentures with interest coupons attached.

  If the distribution is a lump-sum distribution, tax is deferred on all of the NUA unless you choose to include it in your income for the year of the distribution.

   A lump-sum distribution for this purpose is the distribution or payment of a plan participant's entire balance (within a single tax year) from all of the employer's qualified plans of one kind (pension, profit-sharing, or stock bonus plans), but only if paid:

• Because of the plan participant's death,

• After the participant reaches age 59½,

• Because the participant, if an employee, separates from service, or

• After the participant, if a self-employed individual, becomes totally and permanently disabled.

  

If you choose to include NUA in your income for the year of the distribution and the participant was born before January 2, 1936, you may be able to figure the tax on the NUA using the optional methods described under Lump-Sum Distributions, later.

  If the distribution is not a lump-sum distribution, tax is deferred only on the NUA resulting from employee contributions other than deductible voluntary employee contributions.

  The NUA on which tax is deferred should be shown in box 6 of the Form 1099-R you receive from the payer of the distribution.

  When you sell or exchange employer securities with tax-deferred NUA, any gain is long-term capital gain up to the amount of the NUA. Any gain that is more than the NUA is long-term or short-term gain, depending on how long you held the securities after the distribution.

If you borrow money from your retirement plan, you must treat the loan as a nonperiodic distribution from the plan unless it qualifies for the exception explained below. This treatment also applies to any loan under a contract purchased under your retirement plan, and to the value of any part of your interest in the plan or contract that you pledge or assign (or agree to pledge or assign). It applies to loans from both qualified and nonqualified plans, including commercial annuity contracts you purchase directly from the issuer. Further, it applies if you renegotiate, extend, renew, or revise a loan that qualified for the exception below if the altered loan does not qualify. In that situation, you must treat the outstanding balance of the loan as a distribution on the date of the transaction.

You determine how much of the loan is taxable using the allocation rules for nonperiodic distributions discussed under Figuring the Taxable Amount, earlier. The taxable part may be subject to the additional tax on early distributions. It is not an eligible rollover distribution and does not qualify for the 10-year tax option.

If you transfer without full and adequate consideration an annuity contract issued after April 22, 1987, you are treated as receiving a nonperiodic distribution. The distribution equals the excess of:

This rule does not apply to transfers between spouses or transfers incident to a divorce.

If you transfer a full or partial interest in a tax-sheltered annuity that is not subject to restrictions on early distributions to another tax-sheltered annuity, the transfer qualifies for nonrecognition of gain or loss.

If you exchange an annuity contract issued by a life insurance company that is subject to a rehabilitation, conservatorship, or similar state proceeding for an annuity contract issued by another life insurance company, the exchange qualifies for nonrecognition of gain or loss. The exchange is tax free even if the new contract is funded by two or more payments from the old annuity contract. This also applies to an exchange of a life insurance contract for a life insurance, endowment, or annuity contract.

If you transfer part of the cash surrender value of an existing annuity contract for a new annuity contract issued by another insurance company, the transfer qualifies for nonrecognition of gain or loss. The funds must be transferred directly between the insurance companies. Your investment in the original contract immediately before the exchange is allocated between the contracts based on the percentage of the cash surrender value allocated to each contract.

A lump-sum distribution is the distribution or payment in one tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). A distribution from a nonqualified plan (such as a privately purchased commercial annuity or a section 457 deferred compensation plan of a state or local government or tax-exempt organization) cannot qualify as a lump-sum distribution.

The participant's entire balance from a plan does not include certain forfeited amounts. It also does not include any deductible voluntary employee contributions allowed by the plan after 1981 and before 1987.

If you receive a lump-sum distribution from a qualified employee plan or qualified employee annuity and the plan participant was born before January 2, 1936, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify as capital gain subject to a 20% tax rate. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 10-year tax option, discussed later, to figure tax on the ordinary income part.

Each individual, estate, or trust who receives part of a lump-sum distribution on behalf of a plan participant who was born before January 2, 1936 can choose whether to elect the optional methods for the part each received. However, if two or more trusts receive the distribution, the plan participant or the personal representative of a deceased participant must make the choice.

Use Form 4972 , to figure the separate tax on a lump-sum distribution using the optional methods. The tax figured on Form 4972 is added to the regular tax figured on your other income. This may result in a smaller tax than you would pay by including the taxable amount of the distribution as ordinary income in figuring your regular tax.