Taxation of Retirement Benefits

Benefits under a company retirement plan are usually paid out either as a lump sum or as an annuity, with regular payments for a set number of years or for the rest of your life. If the company fully funds the annuity, every dime you receive is taxable. When you have contributed after-tax funds to the plan, however, part of the payments will be tax-free because they are simply a return of your already taxed investment.

Figuring out what's what is quite complicated—for payouts that began before November 19, 1996, that is. For payouts from company plans that began on or after that date, the rules change and things are easier. First, the rules for payouts that began before that November date: The tax-free portion depends on how much after-tax money you have invested and the total you are expected to receive in retirement payments. (Contributions to 401(k) plans, by the way, are generally pre-tax money, so they don't translate to tax-free benefits.) Because annuities usually guarantee payment for the rest of your life, the amount you are expected to receive depends on how long you're expected to live after payments begin.

If you choose a joint-and-survivor annuity—with payments guaranteed during your life and, if you die before your beneficiary, through his or her life, too—the expected return would be based on your joint life expectancy.

Say, for example, that you have contributed $10,000 to a company retirement plan that beginning at age 65 will pay you $200 a month for the rest of your life. According to the IRS's new life-expectancy tables, a 65-year-old is expected to live for 21 years. Assuming you receive $200 a month for 21 years, you will receive payments totaling $50,400. Your $10,000 investment is 19.8% of that total, so 19.8% of each payment you receive would be tax-free.

If you have contributed to your company plan, be sure you get the advice you need to determine what part of the payments you receive is tax-free.

A simpler way — that's getting complicated

A few years ago, the IRS came up with a simplified method for figuring the tax-free portion of payments from qualified plans and 403(b) tax-sheltered annuities. At first, it was an option, but Congress liked it so much that the lawmakers made it mandatory. . .with a minor adjustment. Now, Congress has changed the rules again and the latest change — which went into effect in 1998 — takes away one of the advantages of the original.

First, the good news: Rather than make you rummage through life expectancy tables and struggle with mathematical gymnastics, the simplified method lets you choose a number from a simple table—which groups all taxpayers into five age groups—and divide that number into the total of your after-tax investment in the annuity. The result is the tax-free amount of each payment you receive. Here's the table for annuities starting on or before November 18, 1996.

For annuities starting on or before November 18, 1996

Say, for example, that your total investment in the plan was $25,000 and the annuity began when you were 66. You'd divided $25,000 by 170 to find that $147 of each payment you received is tax-free. The simplified method was an option for annuities that began on or before November 18, 1996. Congress made it mandatory for annuities that started after that date. And, to keep taxpayers and tax advisors on their toes, the lawmakers made some changes to the table. Here's the one that applies to annuities that began from November 19, 1996, through the end of 1997.

For annuities starting after November 18, 1996 and before January 1, 1998

A sweet thing about both tables is that they let you ignore the tax-hiking effect of choosing a joint-and- survivor annuity. Since two beneficiaries have a longer life expectancy—and thus more payments over which to recover the investment—using the simplified method meant more of each payment is tax free than under the old method.

Unfortunately, Congress figured that out and changed the rule again. For annuities starting in 1998 and later years, separate tables are used depending on whether you choose a single- or joint-life annuity. For single-life annuities, the table as is the same as under the old law; but for joint-life annuities, a higher number of payments is based on the combined age of you and your beneficiary. By forcing you to spread recovery of your investment over more payments, the new rule makes you pay more tax sooner on joint-annuities. You use the same joint-life table regardless of how big a payment—100% of your amount, say, or just 50%—your beneficiary will receive after your death.

For annuities starting on or after January 1, 1998—Single Life

For annuities starting on or after January 1, 1998—Joint Life

Pension Income—Playing the Grinch

In the past, if you outlived your life expectancy, you could continue to exclude part of each payment even though you had already recovered your entire investment in the contract. Now, once you have recovered your investment — the $25,000 of after-tax contributions in our example above — 100% of all future payments is taxed.

To be fair, the law also allows a tax deduction on your final tax return if you die before recovering all of your contributions. That won't help you, but it may be important to your heirs if you are receiving partially tax-free annuity payments and die before the age assumed by the life-expectancy tables.

Pension Income—Commercial Annuities

If you buy a commercial annuity—perhaps to supplement your company pension—the simplified method for figuring the tax-free portion of each payment is not available. You must calculate the tax-free part based on the ratio of your cost to your total expected return.

When figuring your tax-free portion, you can't count as part of your investment funds from a traditional IRA or Keogh plan or pre-tax contributions you made to a 401(k) or other tax-sheltered retirement plan. Because those funds and the earnings on them have not yet been taxed, they will be taxable when they are withdrawn—whether directly or via annuity payments.