If the taxpayer contributed “after-tax” dollars to his pension or annuity plan, he can exclude part of each annuity payment from income as a recovery of his cost. This tax-free part of the payment is figured when his annuity starts and remains the same each year, even if the amount of the payment changes. The rest of each payment is taxable. The tax-free portion of the payment is calculated using either the General Rule or the Simplified Method.
The method generally used to determine the tax treatment of pension and annuity income from nonqualified plans is referred to as the General Rule. If the taxpayer’s annuity starting date is after November 18, 1996, he usually cannot use the General Rule for a qualified plan.
The taxpayer must use the General Rule if:
He received pension and annuity payments from a nonqualified plan (such as a private annuity, a purchased commercial annuity, or a nonqualified employee plan); or
He receives a distribution from a qualified plan, and the taxpayer is age 75 or older on his annuity starting date, and his annuity payments are guaranteed for at least 5 years (regardless of his annuity starting date).
The taxpayer can use the General Rule for a qualified plan if his annuity starting date is before November 19, 1996 (but after July 1, 1986), and he does not qualify to use, or chooses not to use, the Simplified Method.
The taxpayer must use the Simplified Method if his annuity starting date is after November 18, 1996, and the taxpayer meets both of the following conditions:
1. The taxpayer receives his pension or annuity payments from any of the following plans:
a. A qualified employee plan.
c. A tax-sheltered annuity plan (403(b) plan).
2. On the annuity starting date, at least one of the following conditions applies to the taxpayer:
a. The taxpayer is under age 75.
b. The taxpayer is entitled to less than 5 years of guaranteed payments.
Using the Simplified Method, the taxpayer will compute the tax-free part of every monthly annuity payment by dividing his cost by the total number of expected monthly payments. For an annuity that is payable for the life of the annuitant, this number is based on the annuitant’s age on the annuity starting date and is determined from a table. For other annuities, this is the number of monthly annuity payments under the contract.