Introduction

This publication gives you the information you need to determine the tax treatment of your pension and annuity income under the General Rule. Generally, each of your monthly annuity payments is made up of two parts: the tax-free part that is a return of your net cost and the taxable balance.

What is the General Rule.    The General Rule is one of the two methods used to figure the tax-free part of each annuity payment based on the ratio of your investment in the contract to the total expected return. The other method is the Simplified Method, which is discussed in Publication 575.

Who must use the General Rule.    Use this publication if you receive pension or annuity payments from:

1. A nonqualified plan (for example, a private annuity, a purchased commercial annuity, or a nonqualified employee plan),
2. A qualified plan if:
   1. Your annuity starting date is before November 19, 1996 (and after July 1, 1986), and you do not qualify to use, or choose not to use, the Simplified Method, or
   2. You are 75 or over and the annuity payments are guaranteed for at least 5 years (regardless of your annuity starting date), or
3. An individual retirement account or annuity (IRA). The life expectancy tables in this publication can help you in computing your minimum required distribution amount, as described in Publication 590, Individual Retirement Arrangements (IRAs).

If your annuity starting date is after November 18, 1996, the General Rule cannot be used for the following qualified plans.

• A qualified employee plan.
• A qualified employee annuity.
• A tax-sheltered annuity (TSA) plan or contract.

If you cannot use the General Rule.    If your annuity starting date is after November 18, 1996, you must use the Simplified Method for annuity payments from a qualified plan. This simplified method is covered in Publication 575, Pension and Annuity Income.

If, at the time the annuity payments began, you were at least 75 and were entitled to annuity payments from a qualified plan with fewer than 5 years of guaranteed payments, you must use the Simplified Method.

Topics not covered in this publication.    Publication 575 covers the tax treatment of nonperiodic payments (amounts not received as an annuity) from a qualified pension or annuity plan, including discussions of rollovers, special averaging, and capital gain treatment of lump-sum distributions. It includes information on the special additional taxes on early distributions, excess distributions, and excess accumulations (not making required minimum distributions).

Life insurance payments.    If you receive life insurance payments because of the death of the insured person, and the payments are from an insurance not connected with the person's job, get Publication 525 for information on the tax treatment of the proceeds.

Help from IRS.    If, after reading this publication, you need help to figure the taxable part of your pension or annuity, the IRS can do it for you for a fee. For information on this service, see Requesting a Ruling on Taxation of Annuity, later.

You can also get help from the employee plans taxpayer assistance telephone service between the hours of 1:30 and 4:00 p.m. Eastern Time, Monday through Thursday, at (202) 622-6074/6075. This is not a toll-free number.

Useful Items You may want to see:

Publication

• 524   Credit for the Elderly or the Disabled
• 525   Taxable and Nontaxable Income
• 571   Tax-Sheltered Annuity Programs for Employees of Public Schools and Certain Tax-Exempt Organizations
• 575   Pension and Annuity Income
• 590   Individual Retirement Arrangements (IRAs) (Including SEP-IRAs and SIMPLE IRAs)
• 721   Tax Guide to U.S. Civil Service Retirement Benefits
• 910   Guide To Free Tax Services

Form (and Instructions)

• 1099-R   Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.

See How To Get More Information, near the end of this publication for information about getting these publications and forms.

General Information

Some of the terms used in this publication are defined in the following paragraphs.

• A pension is generally a series of payments made to you after you retire from work. Pension payments are made regularly and are for past services with an employer.
• An annuity is a series of payments under a contract. You can buy the contract alone or you can buy it with the help of your employer. Annuity payments are made regularly for more than one full year.

Types of pensions and annuities.    Particular types of pensions and annuities include:

1. Fixed period annuities. You receive definite amounts at regular intervals for a definite length of time.
2. Annuities for a single life. You receive definite amounts at regular intervals for life. The payments end at death.
3. Joint and survivor annuities. The first annuitant receives a definite amount at regular intervals for life. After he or she dies, a second annuitant receives a definite amount at regular intervals for life. The amount paid to the second annuitant may or may not differ from the amount paid to the first annuitant.
4. Variable annuities. You receive payments that may vary in amount for a definite length of time or for life. The amounts you receive may depend upon such variables as profits earned by the pension or annuity funds or cost-of-living indexes.
5. Disability pensions. You are under minimum retirement age and receive payments because you retired on disability. If, at the time of your retirement, you were permanently and totally disabled, you may be eligible for the credit for the elderly or the disabled discussed in Publication 524.

If your annuity starting date is after November 18, 1996, the General Rule cannot be used for the following qualified plans.

• A qualified employee plan is an employer's stock bonus, pension, or profit-sharing plan that is for the exclusive benefit of employees or their beneficiaries. This plan must meet Internal Revenue Code requirements. It qualifies for special tax benefits, including tax deferral for employer contributions and rollover distributions, and capital gain treatment or the 5- or 10-year tax option for lump-sum distributions.
• A qualified employee annuity is a retirement annuity purchased by an employer for an employee under a plan that meets Internal Revenue Code requirements.
• A tax-sheltered annuity is a special annuity plan or contract purchased for an employee of a public school or tax-exempt organization.

The General Rule is used to figure the tax treatment of various types of pensions and annuities, including nonqualified employee plans, defined below:

A nonqualified employee plan is an employer's plan that does not meet Internal Revenue Code requirements. It does not qualify for most of the tax benefits of a qualified plan.

Annuity worksheets.    The worksheets found after the text of this publication may be useful to you in figuring the taxable part of your annuity.

Request for a ruling.    If you are unable to determine the income tax treatment of your pension or annuity, you may ask the Internal Revenue Service to figure the taxable part of your annuity payments. This is treated as a request for a ruling. See Requesting a Ruling on Taxation of Annuity at the end of this publication.

Withholding tax and estimated tax.    Your pension or annuity is subject to federal income tax withholding unless you choose not to have tax withheld. If you choose not to have tax withheld from your pension or annuity, or if you do not have enough income tax withheld, you may have to make estimated tax payments.

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 2½ 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 2½ 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:

Net cost		$21,053
Amount to be received annually	$1,200
Number of years for which payment is guaranteed ($21,053 divided by $1,200)	17.54
Rounded to nearest whole number of years	18
Percentage from Actuarial Table VII for age 65 with 18 years of guaranteed payments	15%
Value of the refund feature (rounded to the nearest dollar) - 15% of $21,053		3,158
Investment in the contract, adjusted for value of refund feature		$17,895

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 x 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:

A)	Expected return:*
	1)	Widow's expected return:
		Annual annuity ($171 × 12)	$2,052
		Multiplied by factor from Table V
		(nearest age 48)	34.9	$71,614.80
	2)	Child's expected return:
		Annual annuity ($50 × 12)	$600
		Multiplied by factor from
		Table VIII (nearest age 9
		for term of 9 years)	9.0	5,400.00
	3)	Total expected return		$77,014.80
B)	Adjustment for refund feature:
	1)	Contributions		$7,559.45
	2)	Death benefit exclusion**		5,000.00
	3)	Net cost: B(1) + B(2)		$12,559.45
	4)	Guaranteed amount (contributions of $7,559.45 plus interest of $1,602.53)		$9,161.98
	5)	Minus: Expected return under child's (temporary life) annuity (A(2))		5,400.00
	6)	Net guaranteed amount		$3,761.98
	7)	Multiple from Table VII (nearest age 48 for 2 years duration [recovery of $3,761.98 at $171 a month to nearest whole year])		0%
	8)	Adjustment required for value of refund feature rounded to the nearest whole dollar (0% × $3,761.98, the smaller of B(3) or B(6))

**The death benefit exclusion is discussed earlier.

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.

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