Partially Nontaxable Payments

Some employment-based retirement plans are "noncontributory" — the employer pays for the entire plan on behalf of the employees. Others, such as 401(k) plans, permit employees to make voluntary, pre-tax contributions from their paychecks. Payments from either of these types of plans are fully taxable when the employee eventually receives the benefits.

However, if you, as an employee, made some nondeductible, after-tax contributions to the pension over the years, or if you purchased a commercial annuity with after-tax funds, you can recover the amount of your contributions tax-free over the period you are to receive the payments. A portion of each payment you receive will be nontaxable. Generally, the amount of the after-tax contributions that you received during the year will be shown in Box 5 of the 1099-R, but if your pension began before 1993, the payer is not required to compute this amount.

How is the nontaxable portion of the payment computed? It depends on the date the pension or annuity payments began. Congress has changed the rules several times over the years, so there are a number of different methods that may be applied to your situation.

Payments beginning before November 18, 1996. If the payments began before November 18, 1996, and they are from a qualified retirement plan payable over your life, or your life and that of your beneficiary, you are required to use the "Simplified Method." You can use the worksheet below to figure your taxable annuity amount. After you have recovered your entire cost in the plan, the entire benefit will be fully taxable.

Payments beginning after July 1, 1986 and before November 19, 1996. If the payments began after July 1, 1986 but before November 19, 1996, you may use the Simplified Method if the payments are from a qualified plan; you also have the option of using the General Rule Method. You may be able to switch from one method to the other within three years of your first pension year, by filing an amended return on Form 1040X using your new method for the first pension year and for each subsequent year.

Payments not from qualified plan. If you received the payments from something other than a qualified retirement plan, such as a commercially purchased annuity or a nonqualified plan, you must use the General Rule Method. This method computes your investment in the contract as a percentage of your expected return, based on your life expectancy under IRS tables. With the General Rule Method, as with the Simplified Method, you can exclude the portion of the payments that represent your investment in the plan up to the point where you have recovered your entire cost for the plan; after that point, the entire payment is taxable. For detailed information on how the General Rule works, and worksheets and actuarial tables you can use to compute your taxable benefit amount, get IRS Publication 939, General Rule for Pensions and Annuities.

If the payments began before 1987, you can continue to take your monthly exclusion for as long as you receive the payments, even if you ultimately receive more tax-free benefits than the total amount of your contribution.

Planning Tools You can use this Simplified Method worksheet to figure your taxable annuity. Be sure to keep a copy of this table in your records.

If the payments began after July 1, 1986 but before November 19, 1996, you may use the Simplified Method if the payments are from a qualified plan; you also have the option of using the General Rule Method. You may be able to switch from one method to the other within three years of your first pension year, by filing an amended return on Form 1040X using your new method for the first pension year and for each subsequent year.

If you received the payments from something other than a qualified retirement plan, such as a commercially purchased annuity or a nonqualified plan, you must use the General Rule Method. This method computes your investment in the contract as a percentage of your expected return, based on your life expectancy under IRS tables. With the General Rule method, as with the Simplified Method, you can exclude the portion of the payments that represent your investment in the plan up to the point where you have recovered your entire cost for the plan; after that point, the entire payment is taxable. For detailed information on how the General Rule works, and worksheets and actuarial tables you can use to compute your taxable benefit amount, get IRS Publication 939, General Rule for Pensions and Annuities.

If the payments began before 1987, you can continue to take your monthly exclusion for as long as you receive the payments, even if you ultimately receive more tax-free benefits than the total amount of your contribution.