4088 / Are payments received under a tax sheltered annuity taxable income to the employee?
Yes, except to the extent the amounts are a recovery of the employee’s investment in the contract including the amount of a defaulted loan or to the extent the employee rolls over an eligible distribution to another tax sheltered annuity, a qualified retirement plan, an eligible governmental 457 plan, or a traditional individual retirement plan ( Q 4007).
Where an annuity contract without life insurance protection is used for funding, all payments received normally are taxable in full as ordinary income to the employee. This is the result regardless of whether contributions were made by the employer as additional compensation to the employee, were derived from a reduction in the employee’s salary, or were paid in part by deductible voluntary employee contributions. Because salary reduction contributions have not been previously taxed to the employee, where they have come within the overall limit, they cannot be treated as a cost basis for the contract.1
In some instances, however, the employee will have a cost basis for the contract. An employee’s cost basis consists of any nondeductible contributions the employee has paid and any portion of the contributions made by the employer on which the employee has paid tax, except that excess salary reduction amounts not distributed from the plan by April 15 of the year following the contribution are not included in basis even though they were included in income ( Q 4047). The value of a non-distributed defaulted loan is also included in the employee’s cost basis.