Before you can figure how much, if any, of a distribution from your pension or annuity plan is taxable, you must determine your cost (your investment in the contract) in the pension or annuity. Your total cost in the plan includes everything that you paid. It also includes amounts your employer paid that were taxable to you when paid. Cost does not include any amounts you deducted or excluded from income.

From this total cost paid or considered paid by you, subtract any refunds of premiums, rebates, dividends, unrepaid loans, or other tax-free amounts you received by the later of the annuity starting date or the date on which you received your first payment.

Your annuity starting date is the later of the first day of the first period for which you received a payment, or the date the plan's obligations became fixed.

Your employer or the organization that pays you the benefits (plan administrator) should show your cost in box 5 of your Form 1099-R.

Under the Simplified Method, you figure the tax-free part of each monthly annuity payment by dividing your cost by the total number of expected 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.

How to use the Simplified Method.    Complete the Simplified Method Worksheet in Publication 575 to figure your taxable annuity for 2004. If the annuity is payable only over your life, use your age at the annuity starting date to determine the total number of expected monthly payments for your annuity. For annuity starting dates beginning in 1998, if your annuity is payable over your life and the lives of other individuals, use the combined ages of you and the youngest survivor annuitant at the annuity starting date. However, if your annuity starting date began before January 1, 1998, the total number of monthly annuity payments expected to be received is based on the primary annuitant's age at the annuity starting date.

  

Be sure to keep a copy of the completed worksheet; it will help you figure your taxable annuity in later years.

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 in Worksheet 11-A.

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.

  

Had Bill's retirement annuity payments been from a nonqualified plan, he would have used the General Rule. He uses the Simplified Method Worksheet because his annuity payments are from a qualified plan.

If you receive a survivor annuity because of the death of a retiree who had reported the annuity under the Three-Year Rule, include the total received in income.

If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage to your initial survivor annuity payment called for in the contract. The resulting tax-free amount will then remain fixed. Any increases in the survivor annuity are fully taxable.

If the retiree was reporting the annuity payments under the Simplified Method, the part of each payment that is tax free is the same as the tax-free amount figured by the retiree at the annuity starting date. See Simplified Method, earlier.

In any case, if the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost.

If you are the survivor of an employee, or former employee, who died before becoming entitled to any annuity payments, you must figure the taxable and tax-free parts of your annuity payments using the method that applies as if you were the employee.

If you file Form 1040, report your total annuity on line 16a and the taxable part on line 16b. If your pension or annuity is fully taxable, enter it on line 16b; do not make an entry on line 16a.

If you file Form 1040A, report your total annuity on line 12a and the taxable part on line 12b. If your pension or annuity is fully taxable, enter it on line 12b; do not make an entry on line 12a.

A lump-sum distribution is the distribution or payment in 1 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. For more information about distributions that do not qualify as lump-sum distributions, see Distributions that do not qualify under Lump-Sum Distributions in Publication 575.

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.

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.

If you withdraw cash or other assets from a qualified retirement plan in an eligible rollover distribution, you can defer tax on the distribution by rolling it over to another qualified retirement plan or a traditional IRA.

For this purpose, the following plans are qualified retirement plans.

You generally must complete the rollover by the 60th day following the day on which you receive the distribution from your employer's plan. (This 60-day period is extended for the period during which the distribution is in a frozen deposit in a financial institution.) For all rollovers to an IRA, you must irrevocably elect rollover treatment by written notice to the trustee or issuer of the IRA.

Withholding tax.   If you choose to have all or any part of the distribution paid to you, it is taxable in the year distributed unless you roll it over to another qualified plan or to a traditional IRA within 60 days. The plan administrator must withhold income tax of 20% from the amount of the distribution paid to you. (See Pensions and Annuities under Withholding in chapter 5.)

  

If you decide to roll over an amount equal to the distribution before withholding, your contribution to the new plan or IRA must include other money (for example, from savings or amounts borrowed) to replace the amount withheld.

  The administrator must give you a written explanation of your distribution options within a reasonable period of time before making an eligible rollover distribution.

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on early distributions of those funds and on failures to withdraw the funds timely. Ordinarily, you will not be subject to these taxes if you roll over all early distributions you receive, as explained earlier, and begin drawing out the funds at a normal retirement age, in reasonable amounts over your life expectancy. These special additional taxes are the taxes on:

These taxes are discussed in the following sections.

If you must pay either of these taxes, report them on Form 5329. However, you do not have to file Form 5329 if you owe only the tax on early distributions and your Form 1099-R correctly shows a “1” in box 7. Instead, enter 10% of the taxable part of the distribution on Form 1040, line 59 and write “No” under the heading “Other Taxes” to the left of line 59.

Even if you do not owe any of these taxes, you may have to complete Form 5329 and attach it to your Form 1040. This applies if you meet an exception to the tax on early distributions but box 7 of your Form 1099-R does not indicate an exception.

For this purpose, a qualified retirement plan is:

Exceptions to tax.    Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution code “2,” “3,” or “4” should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329. If an exception applies but distribution code “1” (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions.

  

If distribution code “1” is incorrectly shown on your Form 1099-R for a distribution received when you were age 59½ or older, include that distribution on Form 5329. Enter exception number “11” on line 2.