618 / How are variable annuity benefits taxed to an employee that are payable under a qualified pension or profit sharing plan?

When an employee has a cost basis for an interest in a plan and the annuity starting date is after June 30, 1986, payments are taxed under the annuity rules as expressly applied to variable payments ( Q 550 to Q 552). Thus, the amount excludable from an employee’s gross income each year is determined by dividing the cost basis, adjusted for any refund or period-certain guarantee, by the number of years in the payment period. If an annuity is payable for a life or lives, the payment period is determined by the IRS annuity tables.

For annuities with a starting date after December 31, 1986, the present value of any refund feature is not to be taken into account in calculating the unrecovered investment in the contract, but these amounts still are taken into account in calculating an individual’s exclusion ratio.¹ The unrecovered investment in a contract affects only those annuitants who die before the annuity payments end (i.e., the amount of their deduction on their final year return) ( Q 567) and the annuitant’s cost recovery date (i.e., the date upon which the annuity holder recovers his or her investment in the contract).

Example. Mr. Mounger retired on August 31, 2025 when he had reached age 65. He became eligible to receive monthly variable annuity payments for life under an earlier contributory pension plan of his employer. In the event of Mr. Mounger’s death before receiving payments for at least five years, payments on the same variable basis will be continued to his beneficiary for the remainder of the five-year period. Mr. Mounger contributed $6,000 to the plan ($5,000 representing investment in the contract before July 1, 1986; $1,000 representing investment in the contract after June 30, 1986). Payments for the first year began in September, and during the last four months of the year, Mr. Mounger received a total of $640. Mr. Mounger elects to determine his excludable amount by making separate calculations for his pre-July 1986 and post-June 1986 investment in the contract. The value of the refund feature determined under Table VII of § 1.72-9 is not more than 50 percent, and Mr. Mounger had only life annuity options available. On the basis of these facts, Mr. Mounger’s annual exclusion from gross income will be $343.60. The first step is to adjust the investment in the contract for the value of the refund feature, as follows: