Publication 575 Summarized — Pension and Annuity Income

The answer comes down to one question. Did you ever pay tax on the money that went into the plan? If you did not, the whole payment is taxable when it comes back out. If you did, part of each payment is a tax-free return of money you already paid tax on, and only the rest is taxable. The IRS lays this out in Publication 575, which covers pension and annuity income.

Most workplace pensions fall into the fully taxable bucket. Think of a traditional pension where your employer funded the whole thing, or a 401k where every dollar you put in came out of your paycheck before tax. You got a deduction or an exclusion on the way in, so the IRS taxes all of it on the way out. The same goes for a traditional IRA funded entirely with deductible contributions. When you start drawing from any of these, expect to report the full amount as income on your Form 1040.

The partly taxable bucket is where it gets interesting, and where money gets left on the table if you do not track it. You have what the IRS calls a cost, sometimes called your investment in the contract or your basis, when you put after-tax dollars into the plan. A few common ways this happens. You made nondeductible contributions to a traditional IRA. You contributed to a pension through payroll with money that was already taxed. You bought a commercial annuity with after-tax savings, meaning you wrote a check from money you had already paid income tax on. In all of these cases, you do not owe tax twice on the same dollars. That after-tax money you contributed comes back to you tax-free, spread across your payments.

Here is a plain example. Say you bought an annuity for 100,000 dollars using money from your regular savings account, money that had already been taxed. Over the years the annuity pays out 160,000 dollars total. You do not owe tax on the full 160,000. You owe tax on the 60,000 of growth. The 100,000 you put in is your cost, and it comes back to you tax-free, a little bit at a time, until you have recovered all of it. The method for figuring out how much of each check is tax-free is the Simplified Method, which is a separate question on this page.

One thing that trips people up. Roth accounts work differently and are not really a partly taxable situation in the usual sense. Qualified Roth distributions come out completely tax-free, both the contributions and the earnings, because you paid tax going in and the account met the holding rules. So a Roth IRA or Roth 401k in retirement is usually not taxed at all, which is the opposite of the fully taxable traditional accounts. Knowing which type each of your accounts is matters a great deal for what you actually owe.

Why does the distinction matter so much in real dollars? Because if you have a cost basis and your preparer treats the pension as fully taxable, you overpay tax every single year of retirement. We see this when someone made years of nondeductible IRA contributions, never tracked them on Form 8606, and then their whole distribution gets taxed as if none of it had been after-tax money. That is a real, recurring overpayment. The fix is keeping clean records of what you contributed after-tax, and applying the right method when the payments start. If you are not sure whether your pension or annuity has a cost basis, that is exactly the kind of thing we sort out as part of our individual tax return preparation work, because getting it wrong in year one tends to repeat for a decade.

The short version. No after-tax money in means the whole thing is taxable. After-tax money in means you have a cost, and part of each payment comes back tax-free until that cost is used up. Find out which one you are before you file, not after.

The Simplified Method is the IRS calculation for splitting each pension or annuity payment into two pieces when you have a cost basis. One piece is the tax-free return of the after-tax money you already paid tax on. The other piece is taxable income. You use it so you can recover your cost a little at a time instead of all at once, and so you do not pay tax twice on the same dollars. The full walkthrough lives in Publication 575.

The core idea is dead simple even if the form looks fussy. You take your total cost in the plan, the after-tax money you put in, and you divide it by the total number of payments you are expected to receive. That gives you the tax-free amount per payment. Everything above that amount in each payment is taxable. You keep excluding that same dollar figure from every payment until you have gotten back all of your cost, and after that, every dollar is taxable because you have already recovered everything you paid tax on.

The number of expected payments is not something you guess. The IRS gives you a table based on your age when the payments start, and for some joint annuities, the combined ages of you and a survivor. You look up your age, the table gives you a number of expected monthly payments, and that number is your divisor. A younger retiree has more expected payments, so each one carries a smaller tax-free piece. An older retiree has fewer expected payments, so each one carries a larger tax-free piece. The table does the actuarial work for you.

Walk through a real case. You retire at 65. Your cost in the pension, the after-tax money you contributed, is 31,000 dollars. The IRS table for someone starting at your age says 260 expected payments. Divide 31,000 by 260 and you get about 119 dollars. So 119 dollars of every monthly pension check is tax-free, and the rest is taxable. If your check is 2,000 dollars a month, you report about 1,881 dollars as taxable and exclude 119. You do that for 260 months. Once you have excluded the full 31,000, the entire 2,000 becomes taxable from then on, because your cost is fully recovered.

That last point matters and people miss it. The tax-free piece is not forever. It runs only until you have recovered your whole cost. If you outlive the expected number of payments, congratulations, but every payment after that is fully taxable. There is a flip side too. If you die before recovering your full cost, the unrecovered amount can be claimed as a deduction on your final tax return, so the after-tax money you never got back is not simply lost to tax. That is a detail worth flagging for a surviving spouse or executor.

A word on what the Simplified Method is not. It is not the same as the older General Rule, which used IRS actuarial tables and was harder to apply. For most qualified plans that started after the late 1990s, the Simplified Method is what you are required to use, and frankly it is the easier one. There is also a separate setup for when an annuity has a survivor who continues to receive payments, where the divisor reflects two lives instead of one. The mechanics are the same, the table number just changes.

The thing to protect here is your cost figure. The whole calculation falls apart if you do not know how much after-tax money went into the plan. That number should carry from year to year, and the amount you have already recovered should be tracked so you stop excluding once your cost is used up. We keep that running tally as part of our individual tax return preparation service, because a botched cost figure either overpays you every year or sets up an underpayment the IRS will eventually notice. Get the cost right, pull the correct number from the age table, divide, and the Simplified Method takes care of the rest.

Every time money comes out of a pension, annuity, IRA, or retirement plan, the payer sends you a Form 1099-R and sends a copy to the IRS. This is the form that tells you and the government how much came out and what kind of distribution it was. If you take money from a retirement account during the year, watch your mail in January for this form, because your return depends on it being entered correctly.

Start with the two boxes that drive the tax. Box 1 shows the gross distribution, the total amount that left the account. Box 2a shows the taxable amount, which is the part you actually owe tax on. For a fully taxable pension these two boxes match. For a partly taxable annuity, box 2a should be smaller than box 1, reflecting that some of the payment was a tax-free return of your cost. Here is the catch that costs people money. Sometimes the payer does not know your cost basis, so box 2a is blank or the form says taxable amount not determined. That does not mean the whole thing is taxable. It means you or your preparer has to figure the taxable part using the Simplified Method. Treating a blank box 2a as fully taxable is a common, expensive mistake.

Box 4 shows federal income tax already withheld from the distribution. This is money the payer sent to the IRS on your behalf, and you get credit for it on your return, the same way withholding from a paycheck works. Box 5 can show your after-tax contributions or insurance premiums, depending on the plan, which sometimes helps confirm your cost. Box 7 is the one everyone asks about, because it carries the distribution code that tells the IRS what kind of payment this was.

The box 7 codes are short but they matter. Code 7 means a normal distribution, the kind you take after age 59 and a half, with no penalty attached. Code 1 means an early distribution with no known exception, which is the flag for the 10 percent additional tax. Code 2 means an early distribution but an exception applies, so the payer is signaling the penalty should not hit. Code G means a direct rollover, money moved straight from one plan to another, which is generally not taxable now. Code 4 means a death distribution paid to a beneficiary. Code B points to a Roth account. There are more, but those are the ones that show up most often on a retiree’s form, and each one steers the tax differently.

Why does the code matter so much? Because the IRS reads box 7 before you ever explain anything. If your form shows code 1, their system expects to see the 10 percent early-distribution tax on your return, and if it is missing they send a notice. If you actually qualified for an exception but the payer used code 1 anyway, which happens, you claim the exception yourself on Form 5329 to override the code. The code is the payer’s guess. It is not the final word, and you can correct it with the right form when the payer got it wrong.

One more practical point. The IRA or SEP or SIMPLE box on the form is checked when the distribution came from one of those accounts rather than a workplace pension, and that checkbox changes some of the downstream rules, including how rollovers and the once-per-year IRA rollover limit apply. So do not ignore it. The form is small, but between box 1, box 2a, box 4, and box 7, it carries everything the IRS uses to test your return.

When you hand us a stack of retirement forms, the first thing we do is read every box 7 code and confirm box 2a actually reflects your cost basis rather than a lazy fully taxable default. That review is built into our individual tax return preparation service. A pile of 1099-R forms entered without checking the codes is how people both overpay tax and trigger IRS notices in the same year. Read the form, match the code to what really happened, and the rest of the return follows.

A required minimum distribution, almost always called an RMD, is the amount the IRS makes you pull out of most retirement accounts every year once you reach a certain age. The government let you defer tax on that money for decades. The RMD rules are how it finally collects. You cannot leave the money sitting in a traditional IRA or 401k forever. The framework is spelled out in Publication 575 and the companion IRA rules in Publication 590-B.

The basic mechanic. Once you hit the applicable starting age set by law, you have to take at least a minimum amount out of your traditional retirement accounts each year, and that amount counts as taxable income. The exact starting age has shifted over the past several years as Congress changed the law, so the right age depends on your birth year, and that is something to confirm rather than assume. Roth IRAs are the big exception during the owner’s lifetime, they do not force distributions on the original owner, which is one reason Roth accounts are handy late-life planning tools.

How is the amount figured? You take your account balance from the end of the prior year and divide it by a life expectancy factor from an IRS table. Older account holders have a smaller factor, so a larger slice has to come out each year. The custodian of your account, the bank or brokerage, will usually calculate the figure for you and report it, but the legal responsibility to actually take it is yours. If you have several traditional IRAs, the rules let you add up the total required across them and pull it from any one or any combination, but workplace plans like a 401k generally have to be satisfied account by account. That distinction catches people with both kinds of accounts.

Now the part that should get your attention. Missing an RMD carries a steep penalty. If you do not take the full required amount by the deadline, the IRS hits the shortfall with an additional tax, a meaningful percentage of what you failed to withdraw. This is one of the harshest penalties in the tax code for what is often just an oversight, someone forgot, or thought the custodian handled it automatically, or did not realize an inherited account had its own RMD clock. The penalty applies to the amount you should have taken but did not, so a large missed RMD produces a large penalty.

There is relief, which is the good news. If you missed an RMD for a reasonable cause and you fix it by taking the late distribution, you can ask the IRS to waive the penalty. You do this on Form 5329, where you report the missed amount, take the corrective distribution, and attach a short explanation of what happened and how you corrected it. The IRS has historically been willing to waive the penalty when someone made an honest mistake and moved quickly to fix it. The law also recently reduced the penalty rate and added a smaller rate if you correct the shortfall promptly, so acting fast genuinely pays.

Timing details worth knowing. Your very first RMD has a special grace window, you can delay it into the early part of the following year, but if you do, you end up taking two RMDs in that second year, which can spike your taxable income and push you into a higher bracket. For every year after the first, the deadline is the end of the calendar year. So the first-year delay is a trap as often as it is a help, and whether to use it is a planning decision, not an automatic yes.

Because the penalty is so harsh and the calculation depends on getting the right age and the right table factor, this is something to track deliberately rather than hope the custodian handles. We calendar RMDs for our retirement-age clients and confirm the full required amount actually came out before year end as part of our individual tax return preparation work. The single most expensive RMD error is not a wrong calculation, it is forgetting entirely, and that is the one a deadline on the calendar prevents.

Two separate rules trip up people who touch their retirement money before they reach normal retirement age. The first is a penalty for taking money out too early. The second is a way to move money between accounts without owing any tax at all. They get confused with each other constantly, so it is worth pulling them apart. Both are covered in Publication 575.

Start with the penalty. If you take money out of a retirement account before age 59 and a half, the IRS generally adds a 10 percent additional tax on top of the regular income tax you already owe on that distribution. So an early withdrawal gets hit twice, once at your ordinary income rate and again with the extra 10 percent. Pull 20,000 dollars out of a traditional IRA at age 45 and you owe income tax on the full 20,000 plus a 2,000 dollar penalty. The point of the penalty is to discourage people from raiding retirement savings early, and for most early withdrawals it applies automatically.

But there is a list of exceptions, and they matter because a lot of people qualify and never claim it. The 10 percent tax does not apply if the distribution is for certain reasons. Money taken because you became totally and permanently disabled is exempt. Distributions to a beneficiary after the account owner dies are exempt. Withdrawals to pay medical expenses above a certain percentage of your income can be exempt. A first-time home purchase has a limited exception for IRAs. Higher education costs, certain birth or adoption expenses, and a series of substantially equal periodic payments all have exceptions too. The rules differ a little between IRAs and workplace plans, so the exception that works for a 401k is not always the same one that works for an IRA.

How do you actually claim an exception? If your Form 1099-R shows a code 2 in box 7, the payer already flagged that an exception applies and you are usually fine. But if the form shows code 1, meaning no known exception, and you believe one applies, you claim it yourself on Form 5329. You report the distribution, enter the exception code that fits your situation, and the penalty comes off. We see people pay the 10 percent every year simply because the 1099-R said code 1 and nobody checked whether an exception applied. Do not just accept the code.

Now the better news, rollovers. A rollover lets you move money from one retirement account to another without it counting as a taxable distribution, as long as you follow the rules. Leaving a job and moving your old 401k into an IRA is the classic example. Done right, none of it is taxed now, the money simply continues growing tax-deferred in the new account. The cleanest way is a direct rollover, where the money goes straight from the old plan to the new one and never touches your hands. On the 1099-R, a direct rollover usually shows code G in box 7, and box 2a typically shows zero taxable, which tells the IRS it was a nontaxable transfer.

The dangerous version is the 60-day rollover. If the check comes to you instead, you have 60 days to deposit the full amount into another retirement account or it becomes a taxable distribution, and if you are under 59 and a half, the 10 percent penalty piles on too. Worse, when a workplace plan pays you directly, it is required to withhold 20 percent for taxes, but to complete a full rollover you have to come up with that withheld 20 percent from your own pocket and deposit it too, or that piece gets taxed. There is also a limit of one 60-day IRA-to-IRA rollover in any 12-month period. Miss any of these and a move you thought was tax-free turns into a taxable event with a penalty. Direct rollovers sidestep all of it, which is why we steer clients toward them.

The thread connecting all of this. Moving retirement money is fine and often smart, but the difference between a tax-free rollover and a taxable distribution with a 10 percent penalty is entirely in how you do it and whether you respect the deadlines. We walk clients through job changes, account consolidations, and early-access decisions before the money moves as part of our tax strategy consulting service, because a phone call before you take the check is far cheaper than a Form 5329 after. Know the 59 and a half line, know your exceptions, and use direct rollovers, and your retirement money stays where the tax code lets it grow.