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.

Where a life insurance policy is used ( Q 4034), the sum of the annual one year term costs that have been taxed to the employee are included in the employee’s cost basis.² See Q 4061 regarding the proper measure of the value of current life insurance protection.

Similarly, any portion of an employer’s premiums that have been included in an employee’s gross income because they exceeded the employee’s overall limit are included in the employee’s cost basis ( Q 4042). The amount of any policy loans included in income as a taxable distribution ( Q 4063) also constitutes part of the employee’s cost basis.

Once a loan is deemed distributed under IRC Section 72(p), the interest that accrues thereafter on that loan is not included in income for purposes of determining the amount that is taxable under IRC Section 72. In addition, neither the income that results from the deemed distribution nor the interest that accrues thereafter increases the participant’s investment or cost basis in the contract under IRC Section 72. To the extent that a participant repays by cash any portion of a loan that has been deemed distributed, the participant acquires a tax basis in the contract in the same manner as if the repayments were after-tax contributions.³

If an employee takes an account balance in a single lump sum cash payment, the full amount received will be ordinary income to the employee in the year of receipt unless the employee has a cost basis, except as provided in Q 4057 and Q 4059.If the employee has a cost basis, the amount in excess of the cost basis will be ordinary income.⁴

Amounts received before the annuity starting date, that is, in-service distributions, by an employee who has a cost basis are taxed under a rule that provides for pro rata recovery of cost.⁵ An employee excludes that portion of the distribution that bears the same ratio to the total distribution as the employee’s investment in the contract bears to the total value of the employee’s accrued benefit as of the date of the distribution. Amounts received prior to July 2, 1986 were taxed under a cost recovery rule permitting recovery of basis before taxing any of the distribution as interest.⁶

The annuity starting date is the first day of the first period for which an amount is received as an annuity under a contract ( Q 536).⁷ If a plan on May 5, 1986 permitted in-service withdrawal of employee contributions, the pro rata recovery rules do not apply to investment in the contract prior to 1987. Instead, investment in the contract prior to 1987 will be recovered first and the pro rata recovery rules will apply only to the extent that amounts received before the annuity starting date, when added to all other amounts previously received under the contract after 1986, exceed the employee’s investment in the contract as of December 31, 1986.⁸

If an employee who has a cost basis for his or her contract receives life annuity or installment payments, the payments are taxed as discussed in Q 613, depending on the annuity starting date.

Where the 403(b) annuity contract or custodial account is solely liable for the payment of investment expenses, the direct payment of investment advisor fees from a participant’s annuity or account is not treated as a distribution.⁹ Likewise, where an annuity contract consists of different subaccounts for which a financial advisor provides asset allocation advice, if the annuity contract expenses are assessed directly against the contract value itself, those payments then are expenses of the contract itself and, therefore, are not distributions from the contract includable in gross income. Furthermore, assessing expenses against a contract in this manner does not cause the contract to lose its qualified status under IRC Section 403(b).¹⁰