7.27 Simplified Method for Calculating Taxable Employee Annuity
If you have an investment in the plan and your annuity starting date was in 2012, you must use the simplified method explained below to figure the tax-free portion of your annuity payments from a qualified employer plan, qualified employee annuity, or 403(b) tax-sheltered annuity. The only exception is if you are age 75 or older on your annuity starting date and are entitled to guaranteed annuity payments for at least five years; in that case you must use the six-step method (7.23) for commercial annuities rather than the simplified method.
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Filing Instruction
Simplified Method Mandatory
If your annuity starting date was in 2011, you must use the simplified method (7.27) to figure the taxable part of your 2011 payments, unless on the annuity starting date you were age 75 or older and your payments are guaranteed for at least five years.
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A beneficiary receiving a survivor annuity may use the simplified method.
If your annuity started before 2012 and you have been using the simplified method to report your annuity payments, continue to do so, using the applicable number of expected monthly payments from either Table I or Table II, as discussed below.
Figuring taxable and tax-free payments under the simplified method.
Under the simplified method, a level tax-free portion is determined for each monthly payment with the following steps:
Step 1. Figure your investment in the contract as of the annuity starting date. Include premiums you paid and any after-tax contributions you made to the employer’s pension plan (7.28). If you are the beneficiary of an employee (or former employee) who died before August 21, 1996, also include the death benefit exclusion of up to $5,000 as part of the investment in the contract.
Step 2. Divide the investment from Step 1 by the number of expected monthly payments shown in Table I or Table II below, using your age on the annuity starting date. The result is the tax-free recovery portion of each monthly payment. However, multiply this amount by three (3 months) to get the tax-free portion if payments are made quarterly rather than monthly. The tax-free portion remains the same if a spouse or other beneficiary receives payments under a joint and survivor annuity after the employee’s death.
Table I: Use this table if the annuity starting date was after July 1, 1986, and before January 1, 1998, whether the annuity is based on your life only or is a joint and survivor annuity.
Also use Table I if the annuity starting date was after December 31, 1997, and the annuity is based on your life only.
Table II:Use this table if the annuity starting date is after December 31, 1997, and benefits are based on the life of more than one annuitant. For example, use this table if you started to receive payments in 2012 under a joint and survivor annuity. If there is more than one survivor annuitant, the primary annuitant’s age plus the youngest survivor annuitant’s age is the combined age used for Table II. If there is no primary annuitant and the annuity is payable to several survivor annuitants, the ages of the oldest and youngest are combined. Disregard a survivor annuitant whose entitlement to payment is contingent on something other than the primary annuitant’s death.
Step 3. Multiply the Step 2 result by the number of monthly payments received during the year; this is the total tax-free payment for the year. However, if your annuity starting date was after 1986, your total tax-free recovery under the simplified method for all years is limited to your cost in the plan from Step 1. Thus, you need to keep track of your annual tax-free cost recoveries. The tax-free amount for any year under the Step 3 computation cannot exceed the excess of your investment from Step 1 over the prior year cost recoveries.
Step 4. Subtract the Step 3 tax-free payment from the total pension received this year; this is the taxable pension you must report on Form 1040 or Form 1040A. If the payer of the annuity shows a higher taxable amount on Form 1099-R, use the amount figured here.
EXAMPLE
Fred Smith, age 57, retires and beginning August 1, 2012, he receives payments under a joint and 50% survivor annuity with his wife Betty, also age 57. Fred receives an annuity of $1,500 per month and Betty will receive a survivor annuity of $750 per month after Fred’s death. Fred’s investment in the plan was $29,000. To figure the tax-free portion of each payment, Fred divides his $29,000 investment by 360, the number of expected monthly payments shown in Table II for two annuitants with a combined age of 114 years. The result, or $80.56, is the tax-free portion of each $1,500 payment. The balance of each payment, or $1,419.44 ($1,500 − $80.56), is taxable. On his 2012 return, Fred reports $7,097.20 (5 payments × $1,419.44) as taxable annuity payments.
If Fred dies before the receipt of 360 payments, Betty will also exclude $80.56 from each of her payments of $750 until a total of 360 payments (hers and Fred’s) have been recovered. After 360 payments are received, all subsequent payments will be fully taxable. If Betty dies before the 360th payment, a deduction for the unrecovered investment is allowed on her final income tax return; the deduction is a miscellaneous itemized deduction not subject to the 2% AGI floor.
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