Taxation of Nonperiodic Payments

This section of the publication explains how any nonperiodic distributions you receive under a pension or annuity plan are taxed. Nonperiodic distributions are also known as amounts not received as an annuity. They include all payments other than periodic payments and corrective distributions.

For example, the following items are treated as nonperiodic distributions.

• Cash withdrawals.
• Distributions of current earnings (dividends) on your investment. However, do not include these distributions in your income to the extent the insurer keeps them to pay premiums or other consideration for the contract.
• Certain loans. See Loans Treated as Distributions, later.
• The value of annuity contracts transferred without full and adequate consideration. See Transfers of Annuity Contracts, later.

Corrective distributions of excess plan contributions.   If the contributions made for you during the year to certain retirement plans exceed certain limits, the excess is taxable to you. To correct an excess, your plan may distribute it to you (along with any income earned on the excess). Although the plan reports the corrective distributions on Form 1099-R, the distribution is not treated as a nonperiodic distribution from the plan. It is not subject to the allocation rules explained in the following discussion, it cannot be rolled over into another plan, and it is not subject to the additional tax on early distributions.

If your retirement plan made a corrective distribution of excess contributions (excess deferrals, excess contributions, or excess annual additions), your Form 1099-R should have the code 8, D, P, or E in box 7.

For information on plan contribution limits and how to report corrective distributions of excess contributions, see Retirement Plan Contributions under Employee Compensation in Publication 525.

Figuring the Taxable Amount

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.

You may be able to roll over the taxable amount of a nonperiodic distribution from a qualified retirement plan into another qualified retirement plan or an IRA tax free. See Rollovers, later. If you do not make a tax-free rollover and the distribution qualifies as a lump-sum distribution, you may be able to elect an optional method of figuring the tax on the taxable amount. See Lump-Sum Distributions, later.

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

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 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.

How to report.   Enter the total amount of a nonperiodic distribution on line 16a of Form 1040 or line 12a of Form 1040A. Enter the taxable amount of the distribution on line 16b of Form 1040 or line 12b of Form 1040A. However, if you make a tax-free rollover or elect an optional method of figuring the tax on a lump-sum distribution, see How to report in the discussions of those tax treatments, later.

Distribution On or After Annuity Starting Date

If you receive a nonperiodic payment from your annuity contract on or after the annuity starting date, you generally must include all of the payment in gross income. For example, a cost-of-living increase in your pension after the annuity starting date is an amount not received as an annuity and, as such, is fully taxable.

Reduction in subsequent payments.   If the annuity payments you receive are reduced because you received the nonperiodic distribution, you can exclude part of the nonperiodic distribution from gross income. The part you can exclude is equal to your cost in the contract reduced by any tax-free amounts you previously received under the contract, multiplied by a fraction. The numerator (top part) is the reduction in each annuity payment because of the nonperiodic distribution. The denominator (bottom part) is the full unreduced amount of each annuity payment originally provided for.

Single-sum in connection with the start of annuity payments.   If you receive a single-sum payment on or after your annuity starting date in connection with the start of annuity payments for which you must use the Simplified Method, treat the single-sum payment as if it were received before your annuity starting date. (See Simplified Method under Taxation of Periodic Payments, earlier, for information on its required use.) Follow the rules in the next discussion, Distribution Before Annuity Starting Date From a Qualified Plan.

Distribution in full discharge of contract.   You may receive an amount on or after the annuity starting date that fully satisfies the payer's obligation under the contract. The amount may be a refund of what you paid for the contract or for the complete surrender, redemption, or maturity of the contract. Include the amount in gross income only to the extent that it exceeds the remaining cost of the contract.

Distribution Before Annuity Starting Date From a Qualified Plan

If you receive a nonperiodic distribution before the annuity starting date from a qualified retirement plan, you generally can allocate only part of it to the cost of the contract. You exclude from your gross income the part that you allocate to the cost. You include the remainder in your gross income.

For this purpose, a qualified retirement plan is:

• A qualified employee plan (or annuity contract purchased by such a plan),
• A qualified employee annuity plan, or
• A tax-sheltered annuity plan (403(b) plan).

Use the following formula to figure the tax-free amount of the distribution.

	Amount received	x	Cost of contract	=	Tax-free amount
			Account balance

For this purpose, your account balance includes only amounts to which you have a nonforfeitable right (a right that cannot be taken away).

Example.   Before she had a right to an annuity, Ann Blake received $50,000 from her retirement plan. She had $10,000 invested (cost) in the plan. Her account balance was $100,000. She can exclude $5,000 of the $50,000 distribution, figured as follows:

	$50,000	x	$10,000	=	$5,000
			$100,000

Defined contribution plan.   Under a defined contribution plan, your contributions (and income allocable to them) may be treated as a separate contract for figuring the taxable part of any distribution. A defined contribution plan is a plan in which you have an individual account. Your benefits are based only on the amount contributed to the account and the income, expenses, etc., allocated to the account.

Plans that permitted withdrawal of employee contributions.   If you contributed before 1987 to a pension plan that, as of May 5, 1986, permitted you to withdraw your contributions before your separation from service, any distribution before your annuity starting date is tax free to the extent that it, when added to earlier distributions received after 1986, does not exceed your cost as of December 31, 1986. Apply the allocation described in the preceding discussion only to any excess distribution.

Distribution Before Annuity Starting Date From a Nonqualified Plan

If you receive a nonperiodic distribution before the annuity starting date from a plan other than a qualified retirement plan, it is allocated first to earnings (the taxable part) and then to the cost of the contract (the tax-free part). This allocation rule applies, for example, to a commercial annuity contract you bought directly from the issuer. You include in your gross income the smaller of:

• The nonperiodic distribution, or
• The amount by which the cash value of the contract (figured without considering any surrender charge) immediately before you receive the distribution exceeds your investment in the contract at that time.

Example.   You bought an annuity from an insurance company. Before the annuity starting date under your annuity contract, you received a $7,000 distribution. At the time of the distribution, the annuity had a cash value of $16,000 and your investment in the contract was $10,000. The distribution is allocated first to earnings, so you must include $6,000 ($16,000 - $10,000) in your gross income. The remaining $1,000 is a tax-free return of part of your investment.

Exception to allocation rule.   Certain nonperiodic distributions received before the annuity starting date are not subject to the allocation rule in the preceding discussion. Instead, you include the amount of the payment in gross income only to the extent that it exceeds the cost of the contract.

This exception applies to the following distributions.

• Distributions in full discharge of a contract that you receive as a refund of what you paid for the contract or for the complete surrender, redemption, or maturity of the contract.
• Distributions from life insurance or endowment contracts (other than modified endowment contracts, as defined in section 7702A of the Internal Revenue Code) that are not received as an annuity under the contracts.
• Distributions under contracts entered into before August 14, 1982, to the extent that they are allocable to your investment before August 14, 1982.

If you bought an annuity contract and made investments both before August 14, 1982, and later, the distributed amounts are allocated to your investment or to earnings in the following order.

1. The part of your investment that was made before August 14, 1982. This part of the distribution is tax free.
2. The earnings on the part of your investment that was made before August 14, 1982. This part of the distribution is taxable.
3. The earnings on the part of your investment that was made after August 13, 1982. This part of the distribution is taxable.
4. The part of your investment that was made after August 13, 1982. This part of the distribution is tax free.

Distribution of U.S. savings bonds.   If you receive U.S. savings bonds in a taxable distribution from a retirement plan, report the value of the bonds at the time of distribution as income. The value of the bonds includes accrued interest. When you cash the bonds, your Form 1099-INT will show the total interest accrued, including the part you reported when the bonds were distributed to you. For information on how to adjust your interest income for U.S. savings bond interest you previously reported, see How To Report Interest Income in chapter 1 of Publication 550, Investment Income and Expenses.

Loans Treated as Distributions

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.

Exception for qualified plan, 403(b) plan, and government plan loans.   At least part of certain loans under a qualified employee plan, qualified employee annuity, tax-sheltered annuity (403(b) plan), or government plan is not treated as a distribution from the plan. This exception applies only to a loan that either:

• Is used to buy your main home, or
• Must be repaid within 5 years.

To qualify for this exception, the loan must require substantially level payments at least quarterly over the life of the loan.

If a loan qualifies for this exception, you must treat it as a nonperiodic distribution only to the extent that the loan, when added to the outstanding balances of all your loans from all plans of your employer (and certain related employers) exceeds the lesser of:

• $50,000, or
• Half the present value (but not less than $10,000) of your nonforfeitable accrued benefit under the plan, determined without regard to any accumulated deductible employee contributions.

You must reduce the $50,000 amount above if you already had an outstanding loan from the plan during the 1-year period ending the day before you took out the loan. The amount of the reduction is your highest outstanding loan balance during that period minus the outstanding balance on the date you took out the new loan. If this amount is zero or less, ignore it.

Related employers and related plans.   Treat separate employers' plans as plans of a single employer if they are treated that way under other qualified retirement plan rules because the employers are related. You must treat all plans of a single employer as one plan.

Employers are related if they are:

• Members of a controlled group of corporations,
• Businesses under common control, or
• Members of an affiliated service group.

An affiliated service group generally is two or more service organizations whose relationship involves an ownership connection. Their relationship also includes the regular or significant performance of services by one organization for or in association with another.

Denial of interest deduction.   If the loan from a qualified plan is not treated as a distribution because the exception applies, you cannot deduct any of the interest on the loan during any period that:

• The loan is secured by amounts from elective deferrals under a qualified cash or deferred arrangement (section 401(k) plan) or a salary reduction agreement to purchase a tax-sheltered annuity, or
• You are a key employee as defined in section 416(i) of the Internal Revenue Code.

Reporting by plan.   If your loan is treated as a distribution, you should receive a Form 1099-R showing code L in box 7.

Effect on investment in the contract.   If you receive a loan under a qualified plan (a qualified employee plan or qualified employee annuity) or tax-sheltered annuity plan (403(b) plan) that is treated as a nonperiodic distribution, you must reduce your investment in the contract to the extent that the distribution is tax free under the allocation rules for qualified plans explained earlier. Repayments of the loan increase your investment in the contract to the extent that the distribution is taxable under those rules.

If you receive a loan under a nonqualified plan other than a 403(b) plan, including a commercial annuity contract that you purchase directly from the issuer, you increase your investment in the contract to the extent that the distribution is taxable under the general allocation rule for nonqualified plans explained earlier. Repayments of the loan do not affect your investment in the contract. However, if the distribution is excepted from the general allocation rule (for example, because it is made under a contract entered into before August 14, 1982), you reduce your investment in the contract to the extent that the distribution is tax free and increase it for loan repayments to the extent that the distribution is taxable.

Transfers of Annuity Contracts

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:

• The cash surrender value of the contract at the time of transfer, over
• Your investment in the contract at that time.

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

Tax-free exchange.   No gain or loss is recognized on an exchange of an annuity contract for another annuity contract if the insured or annuitant remains the same. However, if an annuity contract is exchanged for a life insurance or endowment contract, any gain due to interest accumulated on the contract is ordinary income.

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.

In general, a transfer or exchange in which you receive cash proceeds from the surrender of one contract and invest the cash in another contract does not qualify for nonrecognition of gain or loss. However, no gain or loss is recognized if the cash distribution is from an insurance company that is subject to a rehabilitation, conservatorship, insolvency, or similar state proceeding. For the nonrecognition rule to apply, you must also reinvest the proceeds in a single contract issued by another insurance company and the exchange of the contracts must otherwise qualify for nonrecognition. You must withdraw all the cash you can and reinvest it within 60 days. If the cash distribution is less than required for full settlement, you must assign all rights to any future distributions to the new issuer.

If you want nonrecognition treatment for the cash distribution, you must give the new issuer the following information.

• The amount of cash distributed.
• The amount of the cash reinvested in the new contract.
• The amount of your investment in the old contract on the date of the initial distribution.

You must attach the following items to your timely filed income tax return for the year of the initial distribution.

• A copy of the statement you gave to the new issuer.
• A statement that contains the words ELECTION UNDER REV. PROC. 92-44, the new issuer's name, and the policy number or similar identifying information for the new contract.

Tax-free exchange reported on Form 1099-R.   If you make a tax-free exchange of an annuity contract for another annuity contract issued by a different company, the exchange will be shown on Form 1099-R with a code 6 in box 7. You need not report this on your tax return.

Treatment of contract received.   If you acquire an annuity contract in a tax-free exchange for another annuity contract, its date of purchase is the date you purchased the annuity you exchanged. This rule applies for determining if the annuity qualifies for exemption from the tax on early distributions as an immediate annuity.

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