Chapter 7
Retirement and Annuity Income
For employees, coverage in a qualified employer retirement plan is a valuable fringe benefit, as employer contributions are tax free within specified limits. Certain salary-reduction plans allow you to make elective deferrals of salary that are not subject to income tax. An advantage of all qualified retirement plans is that earnings accumulate tax free until withdrawal.
Along with tax savings opportunities come technical restrictions and pitfalls. For example, retirement plan distributions eligible for rollover are subject to a mandatory 20% withholding tax if you receive the distribution rather than asking your employer to make a direct trustee-to-trustee transfer of the distribution to an IRA or another qualified employer plan.
This chapter discusses tax treatment of annuities and employer plan distributions, including how to avoid tax penalties, such as for distributions before age 59½. These distribution rules also generally apply to plans for self-employed individuals; retirement plans for self-employed individuals are discussed further in Chapter 41.
IRAs are discussed in Chapter 8.
A tax credit is available to low-to-moderate income taxpayers who make traditional or Roth IRA contributions, electives deferrals to a 401(k) or other employer plan, and voluntary after-tax contributions to a qualified plan. The credit is discussed in Chapter 25.
7.1 Retirement Distributions on Form 1099-R
7.3 Lump-Sum Options If You Were Born Before January 2, 1936
7.5 Capital Gain Treatment for Pre-1974 Participation
7.6 Lump-Sum Payments Received by Beneficiary
7.7 Tax-Free Rollovers From Qualified Plans
7.8 Direct Rollover or Personal Rollover
7.9 Rollover of Proceeds From Sale of Property
7.10 Distribution of Employer Stock or Other Securities
7.11 Survivor Annuity for Spouse
7.12 Court Distributions to Former Spouse Under a QDRO
7.13 When Retirement Benefits Must Begin
7.15 Penalty for Distributions Before Age 59½
7.16 Restrictions on Loans From Company Plans
7.17 Tax Benefits of 401(k) Plans
7.18 Limit on Salary-Reduction Deferrals
7.19 Withdrawals From 401(k) Plans Restricted
7.20 Designated Roth Contributions to 401(k) Plans
7.21 Annuities for Employees of Tax-Exempts and Schools (403(b) Plans)
7.22 Government and Exempt Organization Deferred Pay Plans
7.23 Figuring the Taxable Part of Your Annuity
7.25 When You Convert Your Endowment Policy
7.26 Reporting Employee Annuities
7.27 Simplified Method for Calculating Taxable Employee Annuity
7.28 Employee’s Cost in Annuity
7.29 Withdrawals From Employer’s Qualified Retirement Plan Before Annuity Starting Date
Table 7-1 Key to Tax-Favored Retirement Plans
| Type— | General Tax Considerations— | Tax Treatment of Distributions— |
| Company qualified plan | A company qualified pension or profit-sharing plan offers these benefits: (1) You do not realize current income on your employer’s contributions to the plan on your behalf. (2) Income earned on funds contributed to your account compounds tax free. (3) Your employer may allow you to make voluntary after-tax contributions. Although these contributions may not be deducted, income earned on the voluntary contributions is not taxed until |
If you collect your retirement benefits as an annuity over a period of years, the part of each payment allocable to your investment is tax free and the rest is taxable (7.27). If you receive a lump-sum payment from the plan, the distribution is generally taxable except to the extent of after-tax contributions you made. Taxable distributions before age 59½ are generally subject to penalties, but there are exceptions (7.15). However, you can avoid immediate tax by making a rollover to withdrawn. a traditional IRA or to another company plan (7.7). If the lump-sum distribution includes company securities, unrealized appreciation on those securities is not taxed until you finally sell the stock (7.10). If you were born before January 2, 1936, and receive a lump sum, tax on employer contributions and plan earnings may be reduced by a special averaging rule (7.4). |
| Plans for self-employed | You may set up a self-employed retirement plan called a Keogh plan if you earn self-employment income through your performance of personal services. You may deduct contributions up to limits discussed in Chapter 41; income earned on assets held by the plan is not taxed. You must include employees in your Keogh under rules explained in Chapter 41. Other retirement plan options, such as a SEP or SIMPLE plan, are also discussed in Chapter 41. |
You may not withdraw Keogh plan funds until age 59½ unless you are disabled or meet other exceptions at 7.15. Qualified distributions to self-employed persons or to beneficiaries at death may qualify for favored lump-sum treatment (7.2). Distributions from a SEP are subject to traditional IRA rules (8.8). Distributions from a SIMPLE-IRA also are subject to traditional IRA rules, but a 25% penalty (instead of 10%) applies to pre-age-59½ distributions in the first two years (8.18). |
| IRA and Roth IRA | Anyone who has earned income may contribute to a traditional IRA, but the contribution is deductible only if certain requirements are met. Your status as a participant in an employer retirement plan and your income determine whether you may claim a deduction up to the annual contribution limit ($5,000 for 2012, $6,000 if age 50 or older), a partial deduction, or no deduction at all. See Chapter 8 for these deduction limitations. Income earned on IRA accounts is not taxed until the funds are withdrawn. This tax-free buildup of earnings also applies where you make nondeductible contributions to a Roth IRA under the rules in Chapter 8. |
Traditional IRA distributions are fully taxable unless you have previously made nondeductible contributions (8.9). A taxable withdrawal before age 59½ is subject to a 10% penalty, but there are exceptions if you are disabled, have substantial medical expenses, pay medical premiums while unemployed, or receive payments in a series of substantially equal installments; see the details on these and other exceptions (8.12). Starting at age 70½, you must receive minimum annual distributions to avoid a 50% penalty (8.13). Distributions from a Roth IRA of contributions are tax free. Distributions of earnings are taxable unless you are over age 59½ and have held the account for at least five years (8.23). |
| Simplified Employee Plan (SEP) | Your employer may set up a SEP and contribute to an IRA more than you can under regular IRA rules (8.15). You are not taxed on employer contributions of up to 25% of your compensation (but no more than $50,000 for 2012). Elective deferrals of salary may be made to qualifying plans set up before 1997 (8.16). | Withdrawals from a SEP are taxable under the rules explained above for IRAs. |
| Deferred salary or 401(k) plans | If your company has a profit-sharing or stock bonus plan, the tax law allows the company to add a cash or deferred pay plan that can operate in one of two ways: (1) Your employer contributes an amount for your benefit to your trust account. (2) You agree to take a salary reduction or to forego a salary increase. The reduction is placed in a trust account for your benefit and is treated as your employer’s contribution, which is tax free within an anual limit (7.18). Income earned on your trust account accumulates tax free until it is withdrawn. | Withdrawals are penalized unless you have reached age 59½, become disabled, or meet other exceptions (7.15). If you were born before January 2, 1936, and receive a qualifying lump sum, tax on the lump sum may be computed according to the rules in 7.2. |