Tax Facts
614 / 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 November 18, 1996 and before January 1, 1998?
If an employee, whether a regular employee or a self-employed individual, has no cost basis for his or her interest in a plan, the full amount of each payment is taxable to the employee as ordinary income.1 If an employee has a cost basis for his or her interest in a plan, the payments are taxed as discussed below, and depend on the employee’s annuity starting date. To determine an employee’s cost basis, see Q 3968.
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 November 18, 1996 and before January 1, 1998 (or if the annuity is payable over one life and has a starting date after December 31, 1997, as described above), the investment in the contract was recovered according to the schedule below. For purposes of this rule, the employee’s investment in the contract did not include any adjustment for a refund feature under the contract.3
The excludable portion of each monthly payment was determined by dividing the employee’s investment in the contract by the number of anticipated payments contained in the following table:4
This table did not apply if the annuitant was age 75 or older unless there were fewer than five years of guaranteed payments under the annuity.5 It would appear that for an annuitant who was 75 or older and whose contract provides for five or more years of guaranteed payments, the rules for annuities with a starting date after July 1, 1986 and before November 19, 1996 would be applied.
If a contract provided for a fixed number of installment payments, the number of monthly annuity payments provided under the contract was used instead of the number listed on the table.6 If payments under a contract were not made on a monthly basis, appropriate adjustments had to be made to the number of payments determined above to reflect the basis on which payments are made.7
The excluded amount remained constant, even where the amount of the annuity payments changes. If the amount to be excluded from each payment was greater than the amount of the annuity payment (e.g., because of decreased survivor payments), then each annuity payment would be completely excluded from gross income until the entire investment is recovered. As noted below, under earlier law, for distributees with annuity starting dates after December 31, 1986, annuity payments received after the investment was recovered are fully includable in gross income. If two annuitants are receiving payments at the same time, each may exclude his or her pro rata portion of the amount provided under these rules.8
If a lump sum was paid to a taxpayer in connection with the commencement of the annuity payments, it was taxable as an amount not received as an annuity under IRC Section 72(e) and treated as received before the annuity starting date. The taxpayer’s investment in the contract was determined as if the lump sum payment had been received.9 Where a defined benefit plan required after-tax contributions and permitted participants to withdraw their aggregate after-tax contributions in a single sum at retirement in exchange for an actuarial reduction in their lifetime pension benefits, the IRS ruled that the single sum payment constituted a lump sum payment under IRC Sections 72(d)(1)(D) and 72(d)(1)(G).10
The total amount that an employee could exclude was not permitted to exceed his or her investment in the contract, and if the employee died prior to recovering his or her full investment in the contract, any unrecovered investment will be allowable as a deduction on the employee’s final return.11
Special transition rules were provided for payors and distributees who continued using the simplified safe harbor contained in Notice 88-118 (see Q 617), as revised by Notice 98-2, with respect to annuities with annuity starting dates after November 18, 1996 and before January 1, 1997.12
1. Treas. Reg. §§ 1.61-11(a), 1.72-4(d)(1); IRC §§ 402(a), 403(a).
2. IRC §§ 402(a), 403(a)(1).
3. IRC §§ 72(d)(1)(C), 72(c)(2); Notice 98-2, 1998-1 CB 266.
4. IRC § 72(d)(1)(B).
5. IRC § 72(d)(1)(E).
6. IRC §§ 72(d)(1)(B)(i)(II), 72(c)(3)(B).
7. IRC § 72(d)(1)(F); see Notice 98-2, 1998-1 CB 266, for two such methods.
8. Notice 98-2, 1998-1 CB 266.
9. IRC § 72(d)(1)(D).
10. Let. Rul. 9847032.
11. IRC §§ 72(d)(1)(B)(ii), 72(b)(2), 72(b)(3); Notice 98-2, 1998-1 CB 266.
12. Notice 98-2, 1998-1 CB 266.
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 November 18, 1996 and before January 1, 1998 (or if the annuity is payable over one life and has a starting date after December 31, 1997, as described above), the investment in the contract was recovered according to the schedule below. For purposes of this rule, the employee’s investment in the contract did not include any adjustment for a refund feature under the contract.3
The excludable portion of each monthly payment was determined by dividing the employee’s investment in the contract by the number of anticipated payments contained in the following table:4
| Age | Number of Payments |
| 55 and under | 360 |
| 56 – 60 | 310 |
| 61 – 65 | 260 |
| 66 – 70 | 210 |
| 71+ | 160 |
This table did not apply if the annuitant was age 75 or older unless there were fewer than five years of guaranteed payments under the annuity.5 It would appear that for an annuitant who was 75 or older and whose contract provides for five or more years of guaranteed payments, the rules for annuities with a starting date after July 1, 1986 and before November 19, 1996 would be applied.
If a contract provided for a fixed number of installment payments, the number of monthly annuity payments provided under the contract was used instead of the number listed on the table.6 If payments under a contract were not made on a monthly basis, appropriate adjustments had to be made to the number of payments determined above to reflect the basis on which payments are made.7
The excluded amount remained constant, even where the amount of the annuity payments changes. If the amount to be excluded from each payment was greater than the amount of the annuity payment (e.g., because of decreased survivor payments), then each annuity payment would be completely excluded from gross income until the entire investment is recovered. As noted below, under earlier law, for distributees with annuity starting dates after December 31, 1986, annuity payments received after the investment was recovered are fully includable in gross income. If two annuitants are receiving payments at the same time, each may exclude his or her pro rata portion of the amount provided under these rules.8
If a lump sum was paid to a taxpayer in connection with the commencement of the annuity payments, it was taxable as an amount not received as an annuity under IRC Section 72(e) and treated as received before the annuity starting date. The taxpayer’s investment in the contract was determined as if the lump sum payment had been received.9 Where a defined benefit plan required after-tax contributions and permitted participants to withdraw their aggregate after-tax contributions in a single sum at retirement in exchange for an actuarial reduction in their lifetime pension benefits, the IRS ruled that the single sum payment constituted a lump sum payment under IRC Sections 72(d)(1)(D) and 72(d)(1)(G).10
The total amount that an employee could exclude was not permitted to exceed his or her investment in the contract, and if the employee died prior to recovering his or her full investment in the contract, any unrecovered investment will be allowable as a deduction on the employee’s final return.11
Special transition rules were provided for payors and distributees who continued using the simplified safe harbor contained in Notice 88-118 (see Q 617), as revised by Notice 98-2, with respect to annuities with annuity starting dates after November 18, 1996 and before January 1, 1997.12
1. Treas. Reg. §§ 1.61-11(a), 1.72-4(d)(1); IRC §§ 402(a), 403(a).
2. IRC §§ 402(a), 403(a)(1).
3. IRC §§ 72(d)(1)(C), 72(c)(2); Notice 98-2, 1998-1 CB 266.
4. IRC § 72(d)(1)(B).
5. IRC § 72(d)(1)(E).
6. IRC §§ 72(d)(1)(B)(i)(II), 72(c)(3)(B).
7. IRC § 72(d)(1)(F); see Notice 98-2, 1998-1 CB 266, for two such methods.
8. Notice 98-2, 1998-1 CB 266.
9. IRC § 72(d)(1)(D).
10. Let. Rul. 9847032.
11. IRC §§ 72(d)(1)(B)(ii), 72(b)(2), 72(b)(3); Notice 98-2, 1998-1 CB 266.
12. Notice 98-2, 1998-1 CB 266.
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