2. Taxable and Nontaxable Income
Generally, income is taxable unless it is specifically exempted (not taxed) by law. Your taxable income may include compensation for services, interest, dividends, rents, royalties, income from partnerships, estate or trust income, gain from sales or exchanges of property, and business income of all kinds.
Under special provisions of the law, certain items are partially or fully exempt from tax. Provisions that are of special interest to older taxpayers are discussed in this chapter.
Compensation for Services
Generally, you must include in gross income everything you receive in payment for personal services. In addition to wages, salaries, commissions, fees, and tips, this includes other forms of compensation such as fringe benefits and stock options.
You need not receive the compensation in cash for it to be taxable. Payments you receive in the form of goods or services generally must be included in gross income at their fair market value.
Volunteer work. Do not include in your gross income amounts you receive for supportive services or reimbursements for out-of-pocket expenses under any of the following volunteer programs.
- Retired Senior Volunteer Program (RSVP).
- Foster Grandparent Program.
- Senior Companion Program.
- Service Corps of Retired Executives (SCORE).
Unemployment compensation. You must include in your income all unemployment compensation you receive.
More information. See Publication 525, Taxable and Nontaxable Income, for more detailed information on specific types of income.
Retirement Plan Distributions
This section summarizes the tax treatment of amounts you receive from certain individual retirement arrangements, employee pensions or annuities, and disability pensions or annuities. More detailed information can be found in Publication 590, Individual Retirement Arrangements (IRAs), or Publication 575, Pension and Annuity Income.
Individual Retirement Arrangements (IRAs)
In general, distributions from a traditional IRA are taxable in the year you receive them. A traditional IRA is any IRA that is not a Roth or SIMPLE IRA. Exceptions to the general rule are rollovers and tax-free withdrawals of contributions, and the return of nondeductible contributions discussed in Publication 590.
If you made nondeductible contributions to a traditional IRA, you must file Form 8606, Nondeductible IRAs. If you do not file Form 8606 with your return, you may have to pay a $50 penalty. Also, when you receive distributions from your traditional IRA, the amounts will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made.
Early distributions. Generally, early distributions are amounts distributed from your traditional IRA account or annuity before you are age 59½, or amounts you receive when you cash in retirement bonds before you are age 59½. You must include early distributions of taxable amounts in your gross income. These taxable amounts are also subject to an additional 10% tax unless the distribution qualifies for an exception. See Tax on Early Distributions, later.
After age 59½ and before age 701/2. After you reach age 59½, you can receive distributions from your traditional IRA without having to pay the 10% additional tax. Even though you can receive distributions after you reach age 59½, distributions are not required until April 1 of the year following the year in which you reach age 70½.
Required distributions. If you are the owner of a traditional IRA, you must receive the entire balance in your IRA or start receiving periodic distributions from your IRA by April 1 of the year following the year in which you reach age 70½. See When Must I Withdraw IRA Assets? (Required Distributions) in Publication 590. If distributions from your traditional IRA(s) are less than the required minimum distribution for the year, you may have to pay a 50% excise tax for that year on the amount not distributed as required. See Tax on Excess Accumulation, later.
Pensions and Annuities
Generally, if you did not pay any part of the cost of your employee pension or annuity, and your employer did not withhold part of the cost of the contract from your pay while you worked, the amounts you receive each year are fully taxable.
If you have a cost to recover from your pension or annuity plan (see Cost, later), you can exclude part of each annuity payment from income as a recovery of your cost. This tax-free part of the payment is figured when your annuity starts and remains the same each year, even if the amount of the payment changes. The rest of each payment is taxable.
You figure the tax-free part of the payment using one of the following methods.
- Simplified Method. You generally must use this method if your annuity is paid under a qualified plan (a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan or contract). You cannot use this method if your annuity is paid under a nonqualified plan.
- General Rule. You must use this method if your annuity is paid under a nonqualified plan. You generally cannot use this method if your annuity is paid under a qualified plan.
You determine which method to use when you first begin receiving your annuity, and you continue using it each year that you recover part of your cost.
Exclusion limit. If you contributed to your pension or annuity and your annuity starting date is before 1987, you can continue to take your monthly exclusion for as long as you receive your annuity. The total exclusion may be more than your cost.
If your annuity starting date is after 1986, the total amount of annuity income you can exclude over the years as a recovery of the cost cannot exceed your total cost.
In either case, any unrecovered cost at your (or the last annuitant's) death is allowed as a miscellaneous itemized deduction on the final return of the decedent. This deduction is not subject to the 2%-of-adjusted-gross-income limit on miscellaneous deductions.
Cost. Before you can figure how much, if any, of your pension or annuity benefits is taxable, you must determine your cost in the plan (your investment). In general, your cost is your net investment in the contract as of the annuity starting date. This includes amounts your employer contributed that were taxable to you when paid.
From this total cost paid or considered paid by you, subtract any refunded premiums, rebates, dividends, unrepaid loans, or other tax-free amounts you received by the later of the annuity starting date or the date on which you received your first payment.
The annuity starting date is the later of the first day of the first period for which you received a payment from the plan or the date on which the plan's obligations became fixed.
The amount of your contributions to the plan may be shown in box 9b of any Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc, that you receive.
Foreign employment contributions. If you worked abroad, certain amounts your employer paid into your retirement plan may be considered part of your cost. For details, see Foreign employment contributions in Publication 575.
Withholding. Your pension, profit-sharing, stock bonus, annuity, or deferred compensation plan will withhold income tax on the taxable part of amounts paid to you. You can choose not to have tax withheld except for amounts paid to you that are eligible rollover distributions. See Withholding Tax and Estimated Tax and Rollovers in Publication 575 for more information.
For payments other than eligible rollover distributions, you can tell the payer how to withhold by filing a Form W-4P, Withholding Certificate for Pension or Annuity Payments.
Simplified Method. Under the Simplified Method, you figure the tax-free part of each annuity payment by dividing your cost by the total number of anticipated monthly payments. For an annuity that is payable over the lives of the annuitants, this number is based on the annuitants' ages on the annuity starting date and is determined from a table. For any other annuity, this number is the number of monthly annuity payments under the contract.
Who must use the Simplified Method. You generally must use the Simplified Method if your annuity starting date is after November 18, 1996, and you receive your pension or annuity payments from a qualified plan or annuity.
In addition, if your annuity starting date is after July 1, 1986, and before November 19, 1996, you generally could have chosen to use the Simplified Method for payments from a qualified plan.
Who cannot use the Simplified Method. You cannot use the Simplified Method and must use the General Rule if you receive pension or annuity payments from:
- A nonqualified plan (such as a private annuity, a purchased commercial annuity, or a nonqualified employee plan), or
- A qualified plan if you are age 75 or older on your annuity starting date and you are entitled to at least 5 years of guaranteed payments.
In addition, you must use the General Rule for payments from a qualified plan if your annuity starting date is after July 1, 1986, and before November 19, 1996, and you did not choose to use the Simplified Method. (You also must use the General Rule for payments from a qualified plan if your annuity starting date is before July 2, 1986, and you did not qualify to use the Three-Year Rule.)
Complete information on the General Rule, including the tables you need, is contained in Publication 939, General Rule for Pensions and Annuities.
Guaranteed payments. Your annuity contract provides guaranteed payments if a minimum number of payments or a minimum amount (for example, the amount of your investment) is payable even if you and any survivor annuitant do not live to receive the minimum. If the minimum amount is less than the total amount of the payments you are to receive, barring death, during the first 5 years after payments begin (figured by ignoring any payment increases), you are entitled to less than 5 years of guaranteed payments.
How to use the Simplified Method. Complete the Simplified Method Worksheet in the Form 1040 or Form 1040A instructions or in Publication 575 to figure your taxable annuity for 2002. If the annuity is payable only over your life, use your age on your annuity starting date to complete line 3 of the worksheet. If your annuity is payable over your life and the lives of other individuals, use your combined ages on the annuity starting date. (However, if your annuity starting date is before 1998, use the primary annuitant's age on the annuity starting date.) If the annuity does not depend on anyone's life expectancy, use the total number of monthly annuity payments under the contract.
Be sure to keep a copy of the completed worksheet; it will help you figure your taxable annuity in later years.
Example. Dale Stanford, age 65, began receiving retirement benefits in 2002, under a joint and survivor annuity. Dale's annuity starting date is January 1, 2002. The benefits are to be paid over the joint lives of Dale and his wife, Kathy, age 65. Dale had contributed $31,000 to a qualified plan and had received no distributions before the annuity starting date. Dale is to receive a retirement benefit of $1,200 a month, and Kathy is to receive a monthly survivor benefit of $600 upon Dale's death.
Dale must use the Simplified Method to figure his taxable annuity because his payments are from a qualified plan and he is under age 75. See his illustrated completed Simplified Method Worksheet, later.
His annuity is payable over the lives of more than one annuitant, so Dale uses his and Kathy's combined ages and Table 2 at the bottom of the worksheet in completing line 3 of the worksheet. Dale's tax-free monthly amount is $100 ($31,000 ÷ 310 as shown on line 4 of the worksheet). Upon Dale's death, if Dale has not recovered the full $31,000 investment, Kathy will also exclude $100 from her $600 monthly payment. The full amount of any annuity payments received after 310 payments are paid must be included in gross income.
If Dale and Kathy die before 310 payments are made, a miscellaneous itemized deduction will be allowed for the unrecovered cost on the final income tax return of the last to die. This deduction is not subject to the 2%-of-adjusted-gross-income limit.
Filled-In Worksheet 2-A. Simplified Method Worksheet for Dale Stanford Keep for Your Records
| 1. |
Enter the total pension or annuity payments received this year. Also, add this amount to the total for Form 1040, line 16a, or Form 1040A, line 12a |
|
|
|
1. |
$ 14,400 |
| 2. |
Enter your cost in the plan (contract) at the annuity starting date |
|
|
|
2. |
31,000 |
| |
Note: If your annuity starting date was before this year and you completed this worksheet last year, skip line 3 and enter the amount from line 4 of last year's worksheet on line 4 below. Otherwise, go to line 3. |
|
|
|
|
|
| 3. |
Enter the appropriate number from Table 1 or 2 below. Use Table 2 if your annuity starting date is after 1997 and payments are for your life and the life of your beneficiary. Otherwise use Table 1 |
|
|
|
3. |
310 |
| 4. |
Divide line 2 by line 3 |
|
|
|
4. |
100 |
| 5. |
Multiply line 4 by the number of months for which this year's payments were made. If your annuity starting date was before 1987, enter this amount on line 8 below and skip lines 6, 7, 10, and 11. Otherwise go to line 6 |
|
|
|
5. |
1,200 |
| 6. |
Enter any amounts previously recovered tax free in years after 1986 |
|
|
|
6. |
0 |
| 7. |
Subtract line 6 from line 2 |
|
|
|
7. |
31,000 |
| 8. |
Enter the smaller of line 5 or line 7 |
|
|
|
8. |
1,200 |
| 9. |
Taxable amount for year. Subtract line 8 from line 1. Enter the result, but not less than zero. Also, add this amount to the total for Form 1040, line 16b, or Form 1040A, line 12b. If your Form 1099-R shows a larger amount, use the amount on this line instead |
|
|
|
9. |
$ 13,200 |
| 10. |
Add lines 6 and 8 |
|
|
|
10. |
1,200 |
| 11. |
Balance of cost to be recovered. Subtract line 10 from line 2 |
|
|
|
11. |
$ 29,800 |
| Table 1 for Line 3 Above |
| | IF the age at annuity starting date was |
| AND your annuity starting date was - |
| |
|
before November 19, 1996, enter on line 3 | after November 18, 1996, enter on line 3 |
| | 55 or under |
300 | 360 |
| | 56-60 |
260 | 310 |
| | 61-65 |
240 | 260 |
| | 66-70 |
170 | 210 |
| | 71 or over |
120 | 160 |
| Table 2 for Line 3 Above |
| |
IF the combined ages at annuity starting date were |
|
THEN enter on line 3 |
|
|
|
| |
110 or under |
|
410 |
|
|
|
| |
111-120 |
|
360 |
|
|
|
| |
121-130 |
|
310 |
|
|
|
| |
131-140 |
|
260 |
|
|
|
| |
141 or over |
|
210 |
|
|
|
Example. Dale Stanford - Filled in Worksheet A
Filled-In Worksheet 2-A. Simplified Method Worksheet for Dale Stanford Keep for Your Records
| 1. |
Enter the total pension or annuity payments received this year. Also, add this amount to the total for Form 1040, line 16a, or Form 1040A, line 12a |
|
|
|
1. |
$ 14,400 |
| 2. |
Enter your cost in the plan (contract) at the annuity starting date |
|
|
|
2. |
31,000 |
| |
Note: If your annuity starting date was before this year and you completed this worksheet last year, skip line 3 and enter the amount from line 4 of last year's worksheet on line 4 below. Otherwise, go to line 3. |
|
|
|
|
|
| 3. |
Enter the appropriate number from Table 1 or 2 below. Use Table 2 if your annuity starting date is after 1997 and payments are for your life and the life of your beneficiary. Otherwise use Table 1 |
|
|
|
3. |
310 |
| 4. |
Divide line 2 by line 3 |
|
|
|
4. |
100 |
| 5. |
Multiply line 4 by the number of months for which this year's payments were made. If your annuity starting date was before 1987, enter this amount on line 8 below and skip lines 6, 7, 10, and 11. Otherwise go to line 6 |
|
|
|
5. |
1,200 |
| 6. |
Enter any amounts previously recovered tax free in years after 1986 |
|
|
|
6. |
0 |
| 7. |
Subtract line 6 from line 2 |
|
|
|
7. |
31,000 |
| 8. |
Enter the smaller of line 5 or line 7 |
|
|
|
8. |
1,200 |
| 9. |
Taxable amount for year. Subtract line 8 from line 1. Enter the result, but not less than zero. Also, add this amount to the total for Form 1040, line 16b, or Form 1040A, line 12b. If your Form 1099-R shows a larger amount, use the amount on this line instead |
|
|
|
9. |
$ 13,200 |
| 10. |
Add lines 6 and 8 |
|
|
|
10. |
1,200 |
| 11. |
Balance of cost to be recovered. Subtract line 10 from line 2 |
|
|
|
11. |
$ 29,800 |
| Table 1 for Line 3 Above |
| | IF the age at annuity starting date was |
| AND your annuity starting date was - |
| |
|
before November 19, 1996, enter on line 3 | after November 18, 1996, enter on line 3 |
| | 55 or under |
300 | 360 |
| | 56-60 |
260 | 310 |
| | 61-65 |
240 | 260 |
| | 66-70 |
170 | 210 |
| | 71 or over |
120 | 160 |
| Table 2 for Line 3 Above |
| |
IF the combined ages at annuity starting date were |
|
THEN enter on line 3 |
|
|
|
| |
110 or under |
|
410 |
|
|
|
| |
111-120 |
|
360 |
|
|
|
| |
121-130 |
|
310 |
|
|
|
| |
131-140 |
|
260 |
|
|
|
| |
141 or over |
|
210 |
|
|
|
Survivors. If you receive a survivor annuity because of the death of a retiree who had reported the annuity under the Three-Year Rule, include the total received in your income. (The retiree's cost has already been recovered tax free.)
If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage the retiree used to your initial payment called for in the contract. The resulting tax-free amount will then remain fixed. Any increases in the survivor annuity are fully taxable.
If the retiree was reporting the annuity payments under the Simplified Method, the part of each payment that is tax free is the same as the tax-free amount figured by the retiree at the annuity starting date. See Simplified Method, earlier.
How to report. If you file Form 1040, report your total annuity on line 16a, and the taxable part on line 16b. If your pension or annuity is fully taxable, enter it on line 16b. Do not make an entry on line 16a. For example, if you received monthly payments totaling $1,200 during 2002 from a pension plan that was completely financed by your employer, and you had paid no tax on the payments that your employer made to the plan, the entire $1,200 is taxable. You include $1,200 only on line 16b, Form 1040.
If you file Form 1040A, report your total annuity on line 12a, and the taxable part on line 12b. If your pension or annuity is fully taxable, enter it on line 12b. Do not make an entry on line 12a.
Joint return. If you file a joint return and you and your spouse each receive one or more pensions or annuities, report the total of the pensions and annuities on line 16a, Form 1040, or line 12a, Form 1040A, and report the total of the taxable parts on line 16b, Form 1040, or line 12b, Form 1040A.
Form 1099-R. You should receive a Form 1099-R for your pension or annuity. Form 1099-R shows your pension or annuity for the year and any income tax withheld.
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