Pensions and Annuities Taxation
Pensions and annuities consist of a stream of payments paid over time, either for a fixed period or for the lifetime of the recipient and, in some cases, for the combined lifetimes of the recipient and a spouse. Money is paid into the fund during the accrual period, where it is invested, then paid out at a set time, either as a lump sum or as periodic payments, usually when the recipient retires. Pensions are usually provided by employers or labor unions and they may fund part or all of it; employees also usually contribute to the fund. Most pensions are funded with pretax dollars; both the contributions and the earnings are tax-deferred until the employee withdraws the money, usually after retirement, when the withdrawals are taxed as ordinary income.
Annuities are generally set up by the taxpayer, usually funded with after-tax income. Annuities are sold and managed by insurance companies, so the security provided by an annuity depends on the creditworthiness of the insurance company paying the annuity. Qualified retirement plans, which are tax-advantaged retirement plans defined by the tax code, are subject to special rules, which are discussed in the referenced article.
Contributions may be tax-deductible or made with pretax income or with after-tax income. If contributions were made with after-tax dollars, such as the case for most annuities, then part of the payments will be considered a return of capital and will not be subject to additional taxes.
Generally, when money is withdrawn from the pension account or from an annuity, the taxable portion of the withdrawals is taxed as ordinary income. Although the tax deferral is a significant benefit, all of the investment income earned by the fund is taxed as ordinary income, including long-term capital gains and qualified dividends, which would otherwise be taxed at a lower rate than ordinary income. Another tax disadvantage is that tax rates may be higher when the payout period begins, although this may be offset if the taxpayer is in a lower tax bracket during the payout period.
Annuity Income and Taxation
If the contributions are considered a return of invested capital, but the earnings are taxed, then the tax-free portion of any distribution is calculated according to the proportion of the total contributions to the total value of the distributions × the amount of the expected distribution. For instance, if an annuity pays a fixed amount for the lifetime of the annuitant, then the total distribution = amount of each distribution × total number of expected payments. If the annuity is for a fixed period, such as 10 years, then the total payments = number of payments per year × number of years in the payout period. If the annuity is for the lifetime of the annuitant, then the expected payout period will depend on the age of the recipient when the payout period begins and the expected lifetime of the recipient based on IRS life expectancy tables, which can be found in Publication 939, General Rule for Pensions and Annuities.
Although the value of an annuity generally increases over time as the annuitant makes payments, it is not taxable to the annuitant because he cannot receive the income until the policy is canceled and because the value of the policy is subject to restrictions.
Payments received after the annuity starting date are taxed in proportion to the exclusion ratio:
Exclusion Ratio = Total Contributions/Total Expected Distributions from the Annuity
Exclusion Amount = Exclusion Ratio × Annuity Payment
The number of expected payments is either based on IRS life expectancy tables or for the contracted number of payments for a fixed period annuity. The exclusion ratio only applies until the annuitant has recovered the investment in the contract; afterwards, the entire payment is taxable.
Example 1: Calculating the Taxable and Tax-Free Portion of an Annuity Payment Using the Exclusion Ratio
If an annuitant receives a fixed annuity and:
- annuitant's expected lifetime: 100 months
- annuity payment to recipient per month: $125
- total contributions: $10,000
- exclusion ratio = $10,000 / ($125 × 100 months) = $10,000/$12,500 = 0.8
- exclusion amount = 0.8 × $125 = $100 = tax-free portion of payment
- taxable portion of payment = payment – tax-free portion of payment = $125 – $100 = $25, until the annuitant receives 100 payments.
Thereafter, the entire portion of each additional payment is taxable.
|Distribution per Month||$1,000|
|Total Distributions per Year||$12,000||= Distribution per Month × Number of Months|
|Life Expectancy in Years||20|
|Total Expected Distribution||$240,000||= Total Distributions per Year × Number of Years|
|Tax-Free Portion of Distribution per Year||$5,000||= Total Distributions per Year × Total Contributions/Total Expected Distribution|
|Taxable Portion of Distribution per Year||$7,000||= Total Distributions per Year – Tax-Free Portion of Distribution|
If the taxpayer lives longer than the expected lifetime, then 100% of all succeeding distributions will be subject to taxation.
Special rules, found in §72(d), apply to annuity distributions from qualified retirement plans. These special rules differ from the exclusion ratio method in that the number of payments is determined according to age groups, such as 55 and under, 56 to 60, and 61 to 65, and so on.
Disability Pensions and Payments
Generally, workers compensation is tax-free, but income from disability pensions provided by an employer is taxable unless the payments are for severe, permanent physical injuries.
Military disability pensions that were received before September 25, 1975 based on years of service are tax-free, but if they are based on the percentage of disability, then they are only tax-free to the extent of that percentage. Payments from military disability pensions other than from the Department of Veterans Affairs (VA) are taxable. VA disability payments are tax-free. Payments for combat-related injuries or sickness is tax-free if they resulted from:
- armed conflict
- hazardous duty
- an instrumentality of war, such as weapons, or
- training for war, including maneuvers
Disability payments received because of a terrorist attack against the United States or its allies or because of US military action are tax-free, regardless of whether the injuries occurred within or without the United States.
Social Security disability benefits are taxed the same as regular Social Security benefits, which are tax-free for lower income taxpayers. Lower income taxpayers can also claim a small tax credit for permanent and total disability.