615 / How is an employee taxed on periodic retirement benefits under a qualified pension, annuity, or profit sharing plan if the annuity starting date is after July 1, 1986 and before November 19, 1996?

The tax treatment is the same whether payment is made directly from a qualified trust or annuity plan or whether a trust buys an annuity and distributes it to an employee.² Distribution of an annuity contract itself affects the tax on lump sum distributions ( Q 140). If an employee has a cost basis for his or her interest, payments are taxed as discussed below, depending on the annuity starting date.

If an employee had a cost basis for his or her interest and the annuity starting date was after July 1, 1986 and before November 19, 1996, payments were taxed either under the regular annuity rules or, if certain requirements were met, under the simplified safe harbor method described in Q 616.³

Under the regular annuity rules, an exclusion ratio was determined as of the annuity starting date.⁴ Basically, the exclusion ratio was determined by dividing the investment in the contract by the expected return under the contract. The resulting quotient was the percentage of each payment that may be excluded from gross income.

With respect to distributions from qualified plans, the employee’s cost basis in the plan was his or her investment in the contract ( Q 527, Q 3968). The total amount that an employee was estimated to receive under a plan was his or her expected return ( Q 534). In the case of a straight life annuity, this expected return was determined by multiplying the total amount an employee will receive each year by the number of years in the employee’s life expectancy, according to Table I or Table V of the Annuity Tables, whichever was applicable. For an explanation of the basic annuity rule and its application to various types of payments (e.g., straight life annuity, refund or period-certain life annuity, joint and survivor annuity, or payments for a fixed period), see Q 527 to Q 546.If an employee’s annuity starting date was after December 31, 1986, the total amount that the employee could exclude during his or her lifetime was limited to his or her investment in the contract. With respect to earlier starting dates, the exclusion ratio continued to apply, even to amounts received in excess of the employee’s investment in the contract.

Example. Mr.?Rowles retired on October 9, 1996, at the age of 65. He had the option under his employer’s qualified contributory pension plan to elect an annuity for a period certain, but chose instead to receive a life annuity. On January 1, 1997, he started receiving payments under the plan. The pension arrangement pays him $800 a month for life. Mr.?Rowles’ cost basis in the plan (including his own contributions and amounts that have been taxed to him) is $12,000. Mr.?Rowles made contributions both before July 1, 1986, and after June 30, 1986, but because Mr.?Rowles could have elected an annuity for a period certain, he may not elect to calculate his excludable amount separately with respect to the pre-July and post-June portions. The life expectancy for age 65 is 20 years (Table V. So, the total expected return from the plan is $192,000 (20 × $9,600). Mr.?Rowles’ exclusion ratio is therefore $12,000/$192,000, or 6.3 percent. Each year he excludes $604.80 (6.3 percent of $9,600) from gross income, until he has excluded the full $12,000, and each year he includes in gross income $8,995.20 ($9,600 – $604.80), until the full $12,000 has been recovered, after which he will include the full $9,600.

If an employee dies prior to recovering his or her full investment in the contract, the unrecovered investment will be allowed as a deduction on the employee’s final return. If payments are guaranteed and a refund beneficiary does not recover the amount unrecovered at the decedent’s death, the beneficiary may deduct the remaining unrecovered investment in the contract.⁵