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Chapter 11. Retirement Plans, Pensions, and Annuities Introduction This chapter discusses the tax treatment of amounts you receive from: ∙ Employee pensions and annuities, ∙ Disability retirement, and ∙ Purchased annuities. Information on amounts you receive from an individual retirement arrangement (IRA), as well as general information on IRAs, is in Chapter 18. Related publications and forms. This chapter refers to several publications and forms that you may need or wish to see. You may want to order the following: Publication 559, Tax Information for Survivors, Executors, and Administrators Publication 575, Pension and Annuity Income (Including Simplified General Rule) Publication 939, Pension General Rule (Nonsimplified Method) Form W─4P, Withholding Certificate for Pension or Annuity Payments Form 4972, Tax on Lump-Sum Distributions Form 5329, Return for Additional Taxes Attributable to Qualified Retirement Plans (Including IRAs), Annuities, and Modified Endowment Contracts Employee 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. You must report them on your income tax return. If you pay part of the cost of your annuity, you are not taxed on the part of the annuity you receive that represents a return of your cost. The rest of the amount you receive is taxable. You use either the General Rule or the Simplified General Rule to figure the taxable and nontaxable parts of your pension or annuity. If your annuity starting date was before July 2, 1986, and you received a total equal to or more than your cost within the first 3 years after you first received your annuity, you should have been reporting your payments under the Three-Year Rule. Under this rule, you excluded all the annuity payments from income until you received a total equal to your cost. After that, all your payments are fully taxable. Railroad retirement benefits. Part of the railroad retirement benefits you receive is treated like social security benefits, and part is treated like an employee pension. For information about railroad retirement benefits treated as an employee pension, see Railroad Retirement in Publication 575, Pension and Annuity Income (Including Simplified General Rule). Credit for the elderly or the disabled. If you receive a pension or annuity, you may be able to take the credit for the elderly or the disabled. See Chapter 34 for information about this credit. Withholding and estimated tax. The payer of your pension, profit-sharing, stock bonus, annuity, or deferred compensation plan will withhold income tax on the taxable parts of amounts paid to you. You can tell the payer how to withhold by filing Form W─4P, Withholding Certificate for Pension or Annuity Payments. You can choose not to have tax withheld. You also make this choice on Form W─4P. If you choose not to have tax withheld, you may have to pay estimated tax. Note: For tax years beginning after 1992 you will no longer be able to elect to have tax not withheld on plans that are eligable to be rolled over but are not transferred to an eligible transferee plan. The withholding rate will be 20%. For more information, see Withholding on Pensions and Annuities and Estimated Tax in Chapter 5. Loans. If you borrow money from an employer's qualified pension or annuity plan, a tax-sheltered annuity program, a government plan, or from a contract purchased under any of these plans, you may have to treat the loan as a distribution. This means that you may have to include in income all or part of the amount borrowed. Even if you do not have to treat the loan as a distribution, you might not be able to deduct the interest on the loan in some situations. For details, see Loans Treated as Distributions in Publication 575. For information on the deductibility of interest, see Chapter 24. Elective deferrals. Some retirement plans allow you to choose (elect) to have part of your pay contributed by your employer to a retirement fund, rather than have it paid to you. Tax on this money is deferred until it is distributed to you. Elective deferrals generally include elective contributions to cash or deferred arrangements (known as section 401(k) plans), section 501(c)(18) plans, salary reduction simplified employee pension (SEP) plans, and tax-sheltered annuities provided for employees of tax-exempt organizations and public schools. For information on the tax treatment of elective deferrals, including their limits, see Elective deferrals under Fully Taxable Payments in Publication 575. H.R. 10 (Keogh) plans. Keogh plans are retirement plans that can only be set up by a sole proprietor or a partnership (but not a partner). They can cover self-employed persons, such as the sole proprietor or partners, as well as regular (common-law) employees. Distributions from these plans are usually fully taxable. If you have an investment (cost) in the plan, however, your pension or annuity payments are taxed under the General Rule or the Simplified General Rule. Deferred compensation plans of state and local governments and tax-exempt organizations. If you participate in one of these plans (known as section 457 plans), you will not be taxed currently on your pay that is deferred under the plan. You or your beneficiary will be taxed on this deferred pay only when it is distributed or otherwise made available to either of you. Distributions of deferred pay are not eligible for 5- or 10-year averaging, rollover treatment, or the death benefit exclusion, all discussed later. Distributions are, however, subject to the tax for failure to make minimum distributions, discussed later. For information on these deferred compensation plans and their limits, see Deferred compensation plans of state and local governments and tax-exempt organizations (section 457 plans) under Fully Taxable Payments in Publication 575. Cost Before you can figure how much, if any, of your pension or annuity benefits is taxable, you must first determine your cost in the plan (your investment). Your total cost in the plan includes everything that you paid. It also includes amounts your employer paid that you were required to include in your income at the time paid. Cost does not include any amounts you deducted or excluded from income or amounts that were not taxable. From this total cost paid or considered paid by you, subtract any refunds of premiums, rebates, dividends, unrepaid loans, or other tax-free amounts you received before the later of the annuity starting date or the date on which you received your first payment. If you use the General Rule to figure the tax treatment of your payments, you must also subtract from your cost the value of any refund feature in your contract. The annuity starting date is the later of the first day of the first period that you receive a payment from the plan or the date on which the plan's obligation became fixed. Your employer or the organization that pays you the benefits (plan administrator) should be able to tell you what your cost is in the plan. Foreign employment. If you worked in a foreign country and your employer paid into your retirement plan, a part of those payments may be considered part of your cost. For details, see Foreign employment in Publication 575. Simplified General Rule If you qualify to use the Simplified General Rule, you will probably find it both simpler and more beneficial than the General Rule, discussed later, in figuring the taxable and nontaxable parts of your annuity. Who can use it. You may be able to use the Simplified General Rule if you are a retired employee or if you are receiving a survivor annuity as the survivor of a deceased employee. You can use it to figure the taxability of your pension only if: ∙ Your annuity starting date is after July 1, 1986, ∙ The annuity payments are for either (a) your life, or (b) your life and that of your beneficiary, ∙ The annuity payments are from a qualified (meeting certain Internal Revenue Code requirements) employee plan, a qualified employee annuity, or a tax-sheltered annuity, and ∙ At the time the payments began, either you were under age 75 or the payments were guaranteed for fewer than 5 years. If you are not sure whether your retirement plan is a qualified plan, ask your employer or plan administrator. Amount of exclusion. If your annuity starting date is after July 1, l986, and before January 1, l987, you continue to take your monthly exclusion (figured on line 4 of the worksheet) for as long as you receive your annuity. If your annuity starting date is after 1986, the total you can exclude over the years is limited to your cost. In both cases, any unrecovered cost at your or the last annuitant's death is allowed as a miscellaneous itemized deduction in the last tax year. This deduction is not subject to the 2% floor on certain miscellaneous itemized deductions. The deduction is taken on the final return of the decedent. If the annuity contract provides for payment to a beneficiary or the estate of the decedent, the deduction for any unrecovered cost is allowed to the person who received the payment. How to use it. If you meet the conditions and you choose the Simplified General Rule, use the following worksheet to figure your taxable pension. In completing this worksheet, use your age at the birthday preceding your annuity starting date. Be sure to keep a copy of the completed worksheet; it will help you figure your 1993 taxable pension. Worksheet for Simplified General Rule 1. Total pension received this year. Also add this amount to the total for Form 1040, line 17a, or Form 1040A, line 11a .... $ __________ 2. Your cost in the plan (contract) at annuity starting date, plus any death benefit exclusion* ......................... __________ 3. Age at annuity starting date: Enter: 55 and under 300 56 ─ 60 260 61 ─ 65 240 66 ─ 70 170 71 and over 120 __________ 4. Divide the amount on line 2 by the number on line 3 .......................... __________ 5. Multiply the amount on line 4 by the number of months for which this year's payments were made ......................... __________ NOTE: If your annuity starting date is before 1987, subtract line 5 from line 1 and enter the result (but not less than zero) on line 9 below. Skip lines 6, 7, 8, 10, and 11. 6. Any amounts previously recovered tax free in years after 1986 ................... __________ 7. Subtract the amount on line 6 from the amount on line 2 ........................... __________ 8. Enter the lesser of the amount on line 5 or the amount on line 7, but no more than the amount on line 1. (If this is zero, your pension is fully taxable.) ...... __________ 9. Taxable pension for year. Subtract the amount on line 8 from the amount on line 1. Also add this amount to the total for Form 1040, line 17b, or Form 1040A, line 11b ................................... $ ========== 10. Add the amounts on lines 6 and 8 .......... $ ========== 11. Balance of cost to be recovered. Subtract the amount on line 10 from the amount on line 2 ...................... $ ========== NOTE: If your Form 1099-R shows a larger taxable amount, use the amount on line 9 instead of the amount from Form 1099-R. *Statement for death benefit exclusion Cost in plan (contract) ....................... $ __________ Death benefit exclusion ....................... __________ Total (enter on line 2 above) ................. $ __________ Signed: __________________________________________________ Date: __________________________________________________ KEEP FOR YOUR RECORDS The following example illustrates the simplified method: Example. Bill Kirkland, age 65, began receiving retirement benefits under a joint and survivor annuity to be paid for the joint lives of Bill and his wife, Kathy. He received his first annuity payment in January 1992. He had contributed $24,000 to the plan and had received no distributions before the annuity starting date. Bill is to receive a retirement benefit of $1,000 a month, and Kathy is to receive a monthly survivor benefit of $500 upon Bill's death. Bill chooses to use the Simplified General Rule computation. He fills in the worksheet as follows: Worksheet for Simplified General Rule 1. Total pension received this year. Also add this amount to the total for Form 1040, line 17a, or Form 1040A, line 11a .... $ 12,000 __________ 2. Your cost in the plan (contract) at annuity starting date, plus any death benefit exclusion* ......................... 24,000 __________ 3. Age at annuity starting date: Enter: 55 and under 300 56 ─ 60 260 61 ─ 65 240 66 ─ 70 170 71 and over 120 240 __________ 4. Divide the amount on line 2 by the number on line 3 ........................... 100 __________ 5. Multiply the amount on line 4 by the number of months for which this year's payments were made ......................... 1,200 __________ NOTE: If your annuity starting date is before 1987, subtract line 5 from line 1 and enter the result (but not less than zero) on line 9 below. Skip lines 6, 7, 8, 10, and 11. 6. Any amounts previously recovered tax free in years after 1986 ................... 0 __________ 7. Subtract the amount on line 6 from the amount on line 2 ........................... 24,000 __________ 8. Enter the lesser of the amount on line 5 or the amount on line 7, but no more than the amount on line 1. (If this is zero, your pension is fully taxable.) ...... 1,200 __________ 9. Taxable pension for year. Subtract the amount on line 8 from the amount on line 1. Also add this amount to the total for Form 1040, line 17b, or Form 1040A, line 11b ................................... $ 10,800 ========== 10. Add the amounts on lines 6 and 8 .......... 1,200 __________ 11. Balance of cost to be recovered. Subtract the amount on line 10 from the amount on line 2 ...................... $ 22,800 ========== NOTE: If your Form 1099-R shows a larger taxable amount, use the amount on line 9 instead of the amount from Form 1099-R. *Statement for death benefit exclusion Cost in plan (contract) ....................... $ __________ Death benefit exclusion ....................... __________ Total (enter on line 2 above) ................. $ ========== Signed: __________________________________________________ Date: __________________________________________________ KEEP FOR YOUR RECORDS Bill's tax-free monthly amount is $100 (see line 4 of the worksheet). If Bill lives to collect more than 240 monthly payments, Bill will have to include in his gross income the full amount of any annuity payments received after 240 payments have been made. If Bill does not live to collect 240 monthly payments and Bill's wife, Kathy, begins to receive monthly payments, she will also exclude $100 from each monthly payment until 240 payments (Bill's and hers) have been collected. If she dies before 240 payments have been made, a miscellaneous itemized deduction (not subject to the 2% floor on miscellaneous deductions) will be allowed for the unrecovered cost on Kathy's final income tax return. Death benefit exclusion. If you are a beneficiary of a deceased employee or former employee, you may qualify for a death benefit exclusion of up to $5,000, discussed later in this chapter. If you choose the Simplified General Rule and you qualify for the death benefit exclusion, you increase your cost in the pension or annuity plan (on line 2 of the worksheet) by the amount of the allowable death benefit exclusion. However, the payer of the annuity cannot add the death benefit exclusion to the cost for reporting the nontaxable and taxable parts of a payment on Form 1099-R. Thus, there will be a difference in the amounts you will figure for yourself and the amounts the payer will figure. You must attach a signed statement to your income tax return stating that you are entitled to the death benefit exclusion in making the Simplified General Rule computation. Or, you may use the statement shown at the bottom of the worksheet. This statement is required every year until the cost in the pension or annuity plan is fully recovered. Example. Diane Greene, age 48, began receiving a $1,500 monthly annuity in 1992 upon the death of her husband. He died before becoming entitled to an annuity. She received 10 payments in 1992. Her husband had contributed $25,000 to his qualified employee plan. In addition, Diane finds that she is entitled to a $5,000 death benefit exclusion for the annuity payments. She adds the exclusion to her husband's contributions to the plan, making her total cost in the plan $30,000. Diane chooses to use the Simplified General Rule. She fills out the worksheet as follows: Worksheet for Simplified General Rule 1. Total pension received this year. Also add this amount to the total for Form 1040, line 17a, or Form 1040A, line 11a .... $ 15,000 __________ 2. Your cost in the plan (contract) at annuity starting date, plus any death benefit exclusion* ......................... 30,000 __________ 3. Age at annuity starting date: Enter: 55 and under 300 56 ─ 60 260 61 ─ 65 240 66 ─ 70 170 71 and over 120 300 __________ 4. Divide the amount on line 2 by the number on line 3 ........................... 100 __________ 5. Multiply the amount on line 4 by the number of months for which this year's payments were made ......................... 1,000 __________ NOTE: If your annuity starting date is before 1987, subtract line 5 from line 1 and enter the result (but not less than zero) on line 9 below. Skip lines 6, 7, 8, 10, and 11. 6. Any amounts previously recovered tax free in years after 1986 ................... 0 __________ 7. Subtract the amount on line 6 from the amount on line 2 ........................... 30,000 __________ 8. Enter the lesser of the amount on line 5 or the amount on line 7, but no more than the amount on line 1. (If this is zero, your pension is fully taxable.) ...... 1,000 __________ 9. Taxable pension for year. Subtract the amount on line 8 from the amount on line 1. Also add this amount to the total for Form 1040, line 17b, or Form 1040A, line 11b ................................... $ 14,000 ========== 10. Add the amounts on lines 6 and 8 .......... 1,000 __________ 11. Balance of cost to be recovered. Subtract the amount on line 10 from the amount on line 2 ...................... $ 29,000 ========== NOTE: If your Form 1099-R shows a larger taxable amount, use the amount on line 9 instead of the amount from Form 1099-R. *Statement for death benefit exclusion Cost in plan (contract) ....................... $ 25,000 __________ Death benefit exclusion ....................... 5,000 __________ Total (enter on line 2 above) ................. $ 30,000 __________ Signed: __________________________________________________ Date: __________________________________________________ KEEP FOR YOUR RECORDS In completing Form 1099-R, the payer of the annuity (the plan administrator) chooses to report the taxable part of the annuity payments using the Simplified General Rule. However, since the payer does not adjust the investment in the contract by the death benefit exclusion, the payer figures the tax-free part of each monthly payment to be $83.33, as follows: Total investment $25,000 (Monthly return ------------------------ = $83.33 of investment) Expected payments: 300 However, Diane had figured a $100 monthly tax-free amount (see line 4 of the worksheet). Because of this difference in the computations, the Form 1099─R given by the payer to Diane will show a greater taxable amount than what she figured for herself. She should report on line 17b of Form 1040 only the smaller taxable amount based on her own computation. She completes and signs the statement at the bottom of the worksheet and attaches it to her income tax return to show that she is entitled to the death benefit exclusion in making the Simplified General Rule computation. She keeps a copy for her records. Changing the method. If your annuity starting date is after July 1, 1986, you can change the way you figure your pension cost recovery exclusion (from the General Rule to the Simplified General Rule, or the other way around) by filing amended returns for all your tax years beginning with the year in which you received your first annuity payment. Generally, however, you can make the change only within 3 years from the due date of your return for the year in which you received your first annuity payment (or, if later, within 2 years from the date the tax for that year was paid). You must use the same method for all years unless you choose the Simplified General Rule for 1988 and later years but not for 1986 or 1987 (see the following discussion). Annuity starting date before 1988. If your annuity starting date was before July 2, 1986, you cannot choose the Simplified General Rule at any time. If your annuity starting date is after July 1, 1986, and before January 1, 1988, you can: 1) Start to use the Simplified General Rule in 1988 without amending your 1986 or 1987 returns, or 2) Amend your 1987 return, if the time period has not expired, to apply the Simplified General Rule to the annuity distributions for that year. If you choose to use the Simplified General Rule beginning in 1988 without amending your prior returns, figure your taxable and nontaxable annuity amounts using your age as of the actual annuity starting date in 1986 or 1987. If you received your first annuity payment in 1987, and you choose to apply the Simplified General Rule to your 1987 distributions, and the time period has not expired, file an amended return for 1987. If you received your first annuity payment in 1986, and the time period for filing an amended return for that year has not yet expired, you can choose to apply the Simplified General Rule to your 1986 and 1987 distributions. You do this by filing amended returns for both 1986 and 1987. You cannot choose the Simplified General Rule for 1987 only, while applying the General Rule to 1986; you must apply the Simplified General Rule to all years beginning with the year in which you received your first annuity payment if you choose to apply it to any of those years. See Changing the method, above. General Rule You must use the General Rule to figure the taxability of your pension or annuity if your annuity starting date is after July 1, 1986, and you do not qualify for, and choose, the Simplified General Rule (explained earlier). You should also be using the General Rule if your annuity starting date was before July 2, 1986, and you did not qualify to use the Three-Year Rule. Under the General Rule, a part of each payment is nontaxable because it is considered a return of your cost. The remainder of each payment (including the full amount of any later cost-of-living increases) is taxable. Finding the nontaxable part is very complex and requires you to use actuarial tables. For a full explanation and the tables you need, get Publication 939, Pension General Rule (Nonsimplified Method). The nontaxable amount remains the same even if the total payment increases. If your annuity starting date was before 1987, you continue to exclude the same nontaxable amount from each annuity payment even if you outlive the life expectancy used to figure your expected return. If your annuity starting date is after 1986, your total exclusion over the years cannot be more than your cost of the contract reduced by the value of any refund feature. If your annuity starting date is after July 1, 1986, and you (or a survivor annuitant) die before the cost is recovered, a miscellaneous itemized deduction is allowed for the unrecovered cost on your, or your survivor's, final income tax return. The deduction is not subject to the 2% floor on certain miscellaneous itemized deductions. How to Report If you file Form 1040, report your total annuity on line 17a and the taxable part on line 17b. If your pension or annuity is fully taxable, enter it on line 17b; no entry is needed on line 17a. If you file Form 1040A, report your total annuity on line 11a and the taxable part on line 11b. If your pension or annuity is fully taxable, enter it on line 11b; no entry is needed on line 11a. If you receive more than one annuity and at least one of them is not fully taxable, enter the total amount received from all annuities on line 17a, Form 1040, or line 11a, Form 1040A, and enter the taxable part on line 17b, Form 1040, or line 11b, Form 1040A. If all the annuities you receive are fully taxable, enter the total of all of them on line 17b, Form 1040, or line 11b, Form 1040A. If you receive benefits from more than one program, such as a pension plan and a profit-sharing plan, you must account for each (figure the taxable part) separately even though the benefits from both may be included in the same check. For example, benefits from one of your programs could be fully taxable, while the benefits from your other program could be taxable under the General Rule or the Simplified General Rule. Your former employer or the plan administrator should be able to tell you if you have more than one program. Report the total of the separately figured amounts on lines 17a and 17b of Form 1040 or lines 11a and 11b of Form 1040A. 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 17a, Form 1040, or line 11a, Form 1040A, and report the taxable part on line 17b, Form 1040, or line 11b, Form 1040A. Survivors. If you, as the survivor of a retiree who had reported an annuity under the Three-Year Rule, receive a survivor annuity, include the total received in income. (The retiree's cost should have already been recovered tax free.) If the retiree was reporting the annuity payments under the General Rule, you should apply to your initial payment called for in the contract the same exclusion percentage as the retiree used. The resulting dollar exclusion will then remain fixed. Increases in the survivor annuity made after the original retiree's annuity starting date are fully taxable. If the retiree had chosen to report the annuity under the Simplified General Rule, the monthly exclusion (arrived at on line 4 of the worksheet shown earlier) remains fixed. You continue to claim this exclusion each month. If the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost minus (if the General Rule is used) the value of any refund feature. If you are a beneficiary of a deceased employee or former employee, you may qualify to add up to $5,000 to the decedent's cost to be recovered tax free. This death benefit exclusion, which is discussed later, is treated as an addition to the cost of the annuity. Estate tax. If the annuity was a joint and survivor annuity and was included in the decedent's estate, an estate tax may have been paid on it. As the surviving annuitant, you can deduct, as a miscellaneous itemized deduction, the part of the total estate tax that was paid because of the annuity. This deduction is not subject to the 2% floor on certain miscellaneous itemized deductions. The deceased annuitant must have died after the annuity starting date. This amount cannot be deducted in one year. It must be deducted equally over your remaining life expectancy. Death Benefit Exclusion If you are the beneficiary of a deceased employee or former employee, the pension or annuity you get because of that person's death may qualify for a death benefit exclusion. This exclusion is limited to $5,000. If you are eligible for the exclusion, add it to the cost or unrecovered cost of the annuity when you figure your cost at the annuity starting date. If you are the survivor under a joint and survivor annuity, the exclusion applies only if either: 1) The decedent died before receiving, or becoming entitled to receive, retirement pension or annuity payments, or 2) The decedent received disability income payments that were not treated as pension or annuity income. For more information on the death benefit exclusion, see Payments to beneficiaries of deceased employees (death benefit exclusion) under Life Insurance Proceeds in Chapter 13, and Death benefit exclusion under Investment in the Contract (Cost) in Publication 575. Lump-Sum Distributions Lump-sum distributions you receive from a qualified retirement plan (an employer's pension, stock bonus, or profit-sharing plan) may be given special tax treatment. A qualified plan is a plan that meets certain requirements of the Internal Revenue Code. For information on a distribution you receive that includes employer securities, see Distributions of employer securities in Publication 575. A lump-sum distribution is the distribution within a single tax year of an employee's entire balance, excluding certain amounts forfeited or subject to forfeiture, from all of the employer's qualified pension plans, all of the employer's qualified stock bonus plans, or all of the employer's qualified profit-sharing plans. The distribution must be paid: 1) Because of the employee's death, 2) After the employee reaches age 59-1/2, 3) Because the employee separates from service, or 4) After a self-employed individual becomes totally and permanently disabled. The separation-from-service condition in (3) does not apply to a self-employed individual. A distribution you receive based on your voluntary deductible employee contributions (DECs) does not qualify as a lump-sum distribution. Tax treatment. You can recover your cost in the lump sum tax free. Also, you may be entitled to special tax treatment for the remaining part of the distribution. In general, your cost consists of: 1) Your total nondeductible contributions to the plan, 2) The total of your taxable one-year term costs of life insurance, 3) Any employer contributions that were taxable to you, and 4) Repayments of loans that were taxable to you. You must reduce this cost by amounts previously distributed to you tax free. Long-term capital gain treatment. If the employee for whom the lump-sum distribution is paid reached age 50 before 1986 (was born before 1936), you can choose to treat a portion of the taxable part of a lump-sum distribution as a long-term capital gain taxable at a 20% (.20) rate. This treatment applies to the portion you receive for the employee's participation in the plan before 1974. A recipient can make only one choice with regard to an employee. Use Form 4972, Tax on Lump-Sum Distributions, to make this choice. Before 1992, regardless of the employee's age, you could report part of the capital gain on Schedule D (Form 1040), if you did not make the choice in the preceding paragraph. The part that is eligible for Schedule D treatment is phased out between 1988 and 1991, and the treatment is be unavailable after 1991. Also, the 20% rate for the choice in the preceding paragraph does not apply. Special averaging method. If the employee for whom the lump-sum distribution is paid reached age 50 before 1986 (was born before 1936), you can elect special averaging of the ordinary income portion of the distribution. (This also includes the capital gain portion of the distribution if you do not choose capital gain treatment for it.) To qualify, you must elect to use special averaging on all lump-sum distributions received in the tax year. To use special averaging for a distribution you receive for your own participation in the retirement plan, you must have been a participant in the plan for at least 5 years. You can only make one lifetime election to use this method for any employee. If you choose the special averaging method, you generally figure your tax, using Form 4972, as though the distribution were received over 5 years. However, you can treat the distribution as though it were received over 10 years instead of 5 years, provided you apply the 1986 tax rates to it. Form 4972 shows how to make this computation. The Form 4972 Instructions contain a special 1986 tax rate schedule that you must use in making the 10-year averaging computation. Form 1099─R. If you receive a total distribution from a plan, you should receive a Form 1099─R, Distributions From Pensions, Annuities, Profit-Sharing or Retirement Plans, IRAs, Insurance Contracts, etc. If the distribution qualifies as a lump-sum distribution, box 3 shows the capital gain, and box 2a minus box 3 is the ordinary income. If you do not get a Form 1099─R, or if you have questions about it, contact your plan administrator. Employee's life insurance proceeds paid in a lump sum under an insurance contract on the death of an employee usually are not taxable. However, any amounts you received that are larger than the face amount of the life insurance are taxable to the extent of the excess. Life insurance proceeds are discussed in Chapter 13. Rollovers Generally, a rollover is a tax-free distribution to you of cash or other assets from a qualified retirement plan that you transfer to an eligible retirement plan (defined below). If you receive 50% or more of the balance to your credit in your employer's qualified plan, you may qualify to roll over the otherwise taxable part of this distribution to another retirement program. You do not pay tax on the amount that is rolled over. The amount you roll over, however, is generally taxable later when it is paid to you or your survivor. You must complete the rollover by the 60th day following the day on which you receive the distribution. (This 60─day period is extended for any time the amount distributed is in a frozen deposit in a financial institution.) For all rollovers to an individual retirement arrangement (IRA), you must irrevocably elect rollover treatment by written notice to the trustee or issuer of the IRA. In general, the most you can roll over is the part that would be taxable if you did not roll it over. From a total distribution, the most you can roll over is the fair market value of all the property you receive, minus any employee contributions you made to the plan (other than accumulated deductible employee contributions). Eligible retirement plan. An eligible retirement plan is an IRA, a qualified employee retirement plan, or a qualified annuity plan. Partial distributions (less than the entire balance to your credit in the plan) may be rolled over only to an IRA. However, a later distribution to you from an IRA will not qualify for the capital gain or special averaging treatment discussed earlier. More information. Since the rules on rollovers are complex, see Rollovers in Publication 575 for details. Deductible voluntary employee contributions. If you receive a distribution from your employer's qualified plan of part of the balance of your accumulated deductible voluntary contributions, you can roll over tax free any part of this distribution. The rollover can be either to an IRA or to certain other qualified plans. Distributions you get as the beneficiary of a deceased employee may be accrued salary payments, distributions from employee profit-sharing, pension, annuity, and stock bonus plans, or other items that should be treated separately for tax purposes. How you treat these distributions depends on what is included in them. Salaries or wages paid after the death of the employee are usually taxable income to you, the beneficiary. If the employee died while still employed, and the employee made contributions to a profit-sharing, pension, annuity, or stock bonus plan, you, as the beneficiary, use the General Rule or the Simplified General Rule (discussed earlier) to figure the taxable amount. The deceased employee's contributions to the plan and the death benefit exclusion, if applicable, are usually your cost. A surviving spouse who, as the beneficiary, receives a lump-sum distribution from a qualified profit-sharing, pension, annuity, or stock bonus plan may qualify to make a tax-free rollover of all or part of the taxable portion of the distribution to an IRA. However, a later distribution to the spouse from an IRA will not qualify for the capital gain or special averaging treatment discussed earlier. See Rollovers in Publications 575 and 590 for more information. Under certain conditions, you also may be eligible for an employee's death benefit exclusion of up to $5,000. See Death Benefit Exclusion, earlier. Bond Purchase Plans The Department of the Treasury stopped issuing U.S. Retirement Plan Bonds after April 30, 1982. They were a special series of interest-bearing bonds that retirement plans could buy. If your plan bought retirement bonds, you can cash them at any time. A beneficiary can cash them after the participant's death. Interest on the bonds stops 5 years after the owner of the bonds dies. They may be cashed at any Federal Reserve Bank branch or at the office of the Treasurer of the United States. If a retirement bond is distributed from a bond purchase plan to you as an employee or beneficiary and you cash in the bond, you are taxed on the amount received minus your cost (normally, any voluntary nondeductible employee payments used to buy that bond). However, you can defer the tax on the amount received by rolling it over to an IRA as discussed under Rollovers in Chapter 18. You can also roll it over to a qualified employer plan (but later distributions of the rollover amount do not qualify for 5- or 10-year averaging or capital gain treatment covered earlier). Tax on Early Distributions Distributions you receive from your qualified retirement plan before you reach age 59-1/2 and amounts you receive when you cash in retirement bonds before you are age 59-1/2 are usually subject to an additional tax of 10% on the taxable part of the distribution. For this purpose, a qualified retirement plan means: 1) A qualified employee retirement plan, 2) A qualified annuity plan, 3) A tax-sheltered annuity plan for employees of public schools or tax-exempt organizations, or 4) An individual retirement arrangement (IRA). Exceptions to tax. The additional tax does not apply to distributions that are: 1) Made to a beneficiary or to the estate of the participant on or after his or her death, 2) Made because you, the participant, are totally and permanently disabled, 3) Made as part of a series of substantially equal periodic (at least annual) payments over your life expectancy or the joint life expectancy of you and your beneficiary, 4) Made to you after separating from service if the separation occurred during or after the calendar year in which you reached age 55, 5) Made to you, to the extent you have deductible expenses for medical care whether or not you itemize deductions for the tax year (This exception applies only to the medical expense that exceeds 7.5% of your adjusted gross income.), 6) Made to alternate payees under qualified domestic relations orders, or 7) Made to you if, as of March 1, 1986, you separated from service and began receiving benefits from the qualified plan under a written election designating a specific schedule of benefit payments. The exception in (3) applies to distributions from non-IRA plans only if the payments begin after you separate from service. The exceptions in (4), (5), (6), and (7) do not apply to IRA distributions. Form 5329. Use Form 5329, Return for Additional Taxes Attributable to Qualified Retirement Plans (Including IRAs), Annuities, and Modified Endowment Contracts, to report the additional tax you owe on the taxable part of the early distribution. You must also file Form 5329 if you meet one of the exceptions listed earlier, but only if the exception is not shown on the Form 1099-R that you received for the distribution. Tax on Excess Distributions If retirement distributions in excess of $150,000 are made to you during the calendar year, you are subject to a 15% excise tax on the excess. The tax is offset by any 10% early withdrawal tax that applies to the excess distribution (see the preceding discussion). Retirement distributions include distributions during the taxable year from qualified employee retirement plans, qualified annuity plans, tax-sheltered annuities, and individual retirement arrangements (IRAs). Excluded distributions. The following distributions are excluded from the tax: ∙ Distributions after death, ∙ Taxable distributions to an alternate payee under a qualified domestic relations order that are includible in the income of the alternate payee, ∙ Distributions attributable to the employee's investment in the contract, ∙ Distributions to the extent rolled over tax free, ∙ Retirement distributions of annuity contracts, the value of which are not included in gross income at the time of the distribution (other than distributions under, or proceeds from the sale or exchange of, such contracts), ∙ Retirement distributions of excess deferrals (and income allocable to them), and ∙ Retirement distributions of excess contributions (and income allocable to them) under section 401(k) plans or IRAs, or excess aggregate contributions (and income on them) under qualified plans. The aggregate contributions relate to highly compensated employees and the plan will figure the excess. For more information, see Exceptions to tax under Tax on Excess Distributions in Publication 575. Combining distributions. If distributions for you are made to you and others, the distributions must be combined in figuring the amount of excess distributions for the year. Lump-sum distributions. A different limit applies if you elect lump-sum distribution treatment (special averaging or capital gain treatment). In this case, the $150,000 annual amount is increased 5 times to $750,000. Then, this increased amount of $750,000 is applied separately to the lump-sum distribution for purposes of figuring the separate tax on the lump-sum distribution. Benefit accruals as of August 1, 1986. If you made a special choice, on a return filed for a tax year beginning before 1989, you can exclude from the tax a prorated part of a distribution that is related to your accrued benefits on August 1, 1986. To have made this special choice, your accrued benefit as of August 1, 1986, must have exceeded $562,500. For more information, see the instructions for Part IV of Form 5329. Form 5329. You must file a Form 5329 if you receive excess distributions from a qualified retirement plan, whether or not you owe tax. Tax for Failure to Make Minimum Distribution If you reach age 70-1/2 after 1987, qualified employee retirement plans, qualified annuity plans, deferred compensation plans under section 457, and tax-sheltered annuity programs (for benefits accruing after 1986) must begin to make distributions to you no later than April 1 of the year following the calendar year in which you reach age 70-1/2. It does not matter whether you are retired. This rule is effective for distribution years beginning after 1988; that is, for distributions required to be made by April 1, l990. Exceptions. The above rule does not apply to governmental plans or church plans. Nor does it apply to any individual (unless a 5% owner) who reached age 70-1/2 before 1988. In these cases, distributions must begin no later than April 1 of the calendar year following the later of: 1) The calendar year in which you reach age 70-1/2, or 2) The calendar year in which you retire. 5% owners. If you are a 5% (or more) owner of the company maintaining the plan, distributions to you must begin by April 1 of the calendar year after the year in which you reach 70-1/2, regardless of when you retire. Also, a later effective date for the above rule may apply to plans maintained under a union-management agreement put into effect before March 1, 1986 (but the rule will be effective not later than plan years beginning after 1990). Minimum distributions. You must either: ∙ Receive your entire interest in the plan by the required beginning date, as explained above, or ∙ Begin receiving regular periodic distributions by that date in an amount large enough to use up the entire interest over your life expectancy or over the joint life expectancies of you and a designated surviving beneficiary (or over a shorter period). Additional information. For more information on this rule, see Tax for Not Making Minimum Distributions in Publication 575. Tax on failure to distribute. If you do not receive these required minimum distributions, you, as the payee, are subject to an excise tax equal to 50% of the difference between the amount that was required to be distributed and the amount that was actually distributed during the tax year. You can get this excise tax excused if you establish that the shortfall in distributions was due to reasonable error and that you are taking reasonable steps to remedy the shortfall. Form 5329. You must file a Form 5329 if you owe a tax because you did not receive a minimum required distribution from your qualified retirement plan. Disability Income Generally, if you retire on disability, you must report your pension or annuity as income. If you were 65 or older at the end of the tax year, or if you were under 65, retired on permanent and total disability, and you received taxable disability income, you may be able to claim the credit for the elderly or the disabled. See Chapter 34 for more information about the credit. Taxable Disability Pensions and Annuities Whether you must report your disability pension or annuity as income depends on how your pension plan is financed. Generally, you must report as income any amount you receive for your disability through an accident or health insurance plan that is paid for by your employer. However, certain payments may not be taxable to you. These payments are discussed in Chapter 13. If the plan does not say that you must pay a specific part of the cost of the disability pension, your employer is considered to provide the disability pension. You must report on your return all payments you receive. If the plan says that you must pay a specific part of the cost of your disability pension, any amounts you receive that are due to your payments to the disability pension are not taxed. You do not report them on your return. They are treated as benefits received under an accident or health insurance policy that you bought. You generally must include in income the rest of the amounts you receive that are due to your employer's payments. If you retired on disability during the past year, any lump-sum payment for accrued annual leave that you received when you retired is a salary payment. The payment is not a disability payment. You should report it as wages in the year you received it. If part of your disability pension is worker's compensation, that part is not taxed. If you die, the part of your survivor's benefit that represents a continuation of the worker's compensation is not taxed. Your employer should be able to give you specific details about your pension plan and to tell you the amount, if any, you paid for your disability pension. How to report. You must report all your taxable disability income on line 7, Form 1040, or line 7, Form 1040A, until you reach minimum retirement age. If you retired on disability and had made contributions to the plan, payments you receive are taxable under the General Rule or Simplified General Rule (discussed earlier) beginning with the day after you reach minimum retirement age. Minimum retirement age generally is the age at which you may first receive a pension or annuity if you are not disabled. Military and Certain Government Disability Pensions Generally, you must report disability pensions as income. But certain military and government disability pensions are not taxable. If your disability pension is taxable, you may be able to take the credit for the elderly or the disabled. See Chapter 34 for more information about the credit. Members of government services. Generally, you must report on your return any disability payments you receive for personal injuries or sickness resulting from active service in the armed forces of any country or in the National Oceanic and Atmospheric Administration, the Public Health Service, or the Foreign Service. However, if you receive a disability pension based on percentage of disability, you do not include the disability payments in your income if: 1) You were entitled to receive a disability payment before September 25, 1975, or 2) You were a member of a government service (or its reserve component), or were under a binding written commitment to become a member on September 24, 1975, or 3) You receive disability payments for a combat-related injury, or 4) You would be entitled to receive disability compensation from the Department of Veterans Affairs (VA) if you filed an application for it. Combat-related injury means personal injury or sickness that: 1) Directly results from armed conflict, 2) Takes place while you are engaged in extra-hazardous service, 3) Takes place under conditions simulating war, including training exercises such as maneuvers, or 4) Is caused by an instrumentality of war. Disability based on years of service. If you receive a disability pension based on years of service, you generally must include it in your income. But if you fall into one of the four categories listed above under Members of government services, do not include in income the part of your pension that you would have received if the pension had been based on percentage of disability. You must include the rest of your pension in income. If part of your disability pension is taxable, you may be able to take the credit for the elderly or the disabled. See Chapter 34 for more information about the credit. Terrorist attack. You do not include disability payments in income if you receive them for injuries directly resulting from a violent attack that occurred while you were a U.S. government employee performing official duties outside the United States. For your disability payments to be tax exempt, the Secretary of State must determine that the attack was a terrorist attack. Disability benefits you receive from the VA are not included in your gross income. If you are a military retiree and do not receive your disability benefits from the VA, do not include in income the amount of disability benefits equal to the VA benefits to which you are entitled. If you retire from the armed services (based on years of service) and at a later date are given a retroactive service-connected disability rating by the VA, do not include in income for the retroactive period the part of your retirement pay you would have been entitled to receive from the VA during that period. However, you must include in income any lump-sum readjustment payment you received on release from active duty, even though you are later given a retroactive disability rating by the VA. Purchased Annuities If you purchased an annuity contract from a commercial organization, such as an insurance company, you must use the General Rule to figure the part of each annuity payment you receive that is not taxed. For more information, get Publication 939, Pension General Rule (Nonsimplified Method). Sale of annuity. Gain on the sale of an annuity contract before its maturity date is ordinary income to the extent that the gain is due to interest accumulated on the contract. You do not recognize gain or loss on an exchange of an annuity contract solely for another annuity contract. Tax on early withdrawals. A penalty tax of 10% is imposed on amounts you withdraw from your deferred annuity contract before age 59-1/2. This is referred to as the section 72(q) tax. For exceptions to this penalty, see Tax on early withdrawals from deferred annuity contracts in Publication 575.