Tax time can be particularly confusing when you have pension or annuity income. The Internal Revenue Service (IRS) says that some or all of the amounts you receive from these sources can be taxable. How they're taxed depends on various factors. Fortunately, the IRS offers various tools for calculations.
- Taxation of pension or annuity income depends on whether you contributed to the plan with before-tax or after-tax dollars.
- Claiming a tax deduction for contributions makes them taxable upon withdrawal.
- Not claiming a tax deduction at the time you made the contribution makes the income tax-free upon distribution.
- You must calculate how taxes will be paid using one of two methods depending on the starting date of your plan: the general rule or the simplified method.
The Taxable Portion of Your Pensions and Annuities
The IRS says that your payments are partially taxable if your contributions to your pension or annuity were made with after-tax dollars. You won't pay tax on the portion of the payments that represent a return of the after-tax amount you paid in. These contributions represent your cost in the plan or investment. They include amounts that your employer might have contributed that were taxable to you as income at the time they were made.
Any contributions that you made with after-tax income, those for which you never took a tax deduction, aren't taxable to you at the time of distribution. This includes contributions your employer made on your behalf but which were attributed to you as income, so you claimed them on your tax returns and paid taxes on the amounts when they were contributed.
The General Rule vs. the Simplified Method
You must determine the method by which the remaining amounts will be taxed. Partly taxable pensions and annuities are taxed under either the General Rule or the Simplified Method.
You must use the General Rule if your annuity or pension payments began on or before November 18, 1996. You can use the Simplified Method to pin down the taxable portion if your pension or annuity payments began after that date.
You're restricted to using the General Rule if the starting date of your annuity was between July 1, 1986 and November 18, 1996, and if you don't qualify to use the Simplified Method.
You must also use the General Rule if your starting date is after November 18, 1996, you were age 75 or older as of that date, and your payments were guaranteed for at least five years.
You're limited to using the General Rule if you've received payments from a nonqualified plan. A qualified retirement plan is a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan.
The General Rule
The General Rule requires that you use the life expectancy or "actuarial" tables provided by the IRS to figure the taxable and tax-free portions of your payments. They're included in IRS Publication 939, General Rule for Pensions and Annuities. The publication also walks you through the calculations for your taxable pension and annuity under the General Rule.
The IRS will calculate your taxable pension income under the General Rule for you for a nominal fee if you don't want to risk making a mistake.
The easiest, safest option might be to have a tax professional or have the IRS make these calculations for you.
The Simplified Method
The IRS says you can use the Simplified Method to determine how much of your annuity or pension payments is taxable and how much is tax-free if the starting date of payments was after November 18, 1996. The IRS provides a Simplified Method Worksheet to help you along.
How to Report Pension and Annuity Income
Separate any 1099-R statements you receive into two piles: those from your IRA, and those from your pension or annuity plans. You'll report your IRA distributions on lines 4a and 4b of the 2021 Form 1040. Report your pension and annuity distributions on lines 5a and 5b. The a column is for your total distributions. The b column segregates the taxable amount.
These lines may differ on tax returns on an annual basis. The IRS has revised Form 1040 a number of times since 2017. The appropriate lines can change by tax year. These lines apply to the 2021 tax return you'll file in 2022.
Frequently Asked Questions (FAQs)
What is a pension?
A pension is an employer-sponsored retirement plan. The employer contributes to a pool of money that's paid out to eligible retired employees. Employees can contribute as well to some plans. The pension payout is determined by your pay at the time you retired and your years of service.
What is an annuity?
An annuity is a type of insurance. You pay a premium to an insurance company, and you receive a guaranteed income for the rest of your life. An annuity can be immediate, which means your premium is converted into income right away, or deferred, which means it can be converted into income later. The funds in deferred annuities can earn a fixed interest rate, follow an index, or they can be invested.