IRS Publication 17, Chapter 11, Retirement Plans, Pensions, and Annuities

Introduction

This chapter discusses the tax treatment of distributions you receive from:

An employee pension or annuity from a qualified plan,
A disability retirement, and
A purchased commercial annuity.

What is not covered in this chapter. The following topics are not discussed in this chapter.

The General Rule. This is the method generally used to determine the tax treatment of pension and annuity income from nonqualified plans (including commercial annuities). If your annuity starting date is after November 18, 1996, you generally cannot use the General Rule for a qualified plan. For more information about the General Rule, see Publication 939.

Civil service retirement benefits. If you are retired from the federal government (either regular or disability retirement), see Publication 721, Tax Guide to U.S. Civil Service Retirement Benefits. Publication 721 also covers the information that you need if you are the survivor or beneficiary of a federal employee or retiree who died.

Individual retirement arrangements (IRAs). Information on the tax treatment of amounts you receive from an IRA is in chapter 18.

Useful Items - You may want to see:

Publication

575 Pension and Annuity Income
721 Tax Guide to U.S. Civil Service Retirement Benefits
939 General Rule for Pensions and Annuities

Form (and Instructions)

W-4P
Withholding Certificate for Pension or Annuity Payments
1099-R
Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.
4972
Tax on Lump-Sum Distributions
5329
Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts

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 from your pay while you worked, the amounts you receive each year are fully taxable. You must report them on your income tax return.

Partly taxable payments. If you paid 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. Your annuity starting date (defined later) determines which method you must or may use.

If you contributed to your pension or annuity plan, you figure the tax-free and the taxable parts of your annuity payments under either the Simplified Method or the General Rule. If your annuity starting date is after November 18, 1996, and your payments are from a qualified plan, you must use the Simplified Method. Generally, you must use the General Rule only for nonqualified plans.

If your annuity is paid under a qualified plan and your annuity starting date is after July 1, 1986 and before November 19, 1996, you could have chosen to use either the General Rule or the Simplified Method.

More than one program. If you receive benefits from more than one program under a single trust or plan of your employer, such as a pension plan and a profit-sharing plan, you may have to figure the taxable part of each separately. 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 Method. Your former employer or the plan administrator should be able to tell you if you have more than one pension or annuity contract.

Railroad retirement benefits. Part of the railroad retirement benefits you receive is treated for tax purposes like social security benefits, and part is treated like an employee pension. For information about railroad retirement benefits treated as social security benefits, see Publication 915, Social Security and Equivalent Railroad Retirement Benefits. For information about railroad retirement benefits treated as an employee pension, see Railroad Retirement in Publication 575.

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 35.

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 choose not to have tax withheld except for amounts paid to you that are eligible rollover distributions. See Eligible rollover distributions under Rollovers, later. You make this choice by filing Form W-4P.

For payments other than eligible rollover distributions, you can tell the payer how to withhold by filing Form W-4P. If an eligible rollover distribution is paid directly to you, 20% will generally be withheld. There is no withholding on a direct rollover of an eligible rollover distribution. See Direct rollover option under Rollovers, later. If you choose not to have tax withheld or you do not have enough tax withheld, you may have to pay estimated tax.

For more information, see Pensions and Annuities under Withholding in chapter 5.

Loans. If you borrow money from your qualified pension or annuity plan, tax-sheltered annuity program, government plan, or contract purchased under any of these plans, you may have to treat the loan as a nonperiodic distribution unless certain exceptions apply. This means that you must include in income all or part of the amount borrowed. Even if you do not have to treat the loan as a nonperiodic distribution, you may 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 25.

Qualified plans for self-employed individuals. Qualified plans set up by self-employed individuals are sometimes called Keogh or H.R. 10 plans. Qualified plans can be set up by sole proprietors, partnerships (but not a partner), and corporations. They can cover self-employed persons, such as the sole proprietor or partners, as well as regular (common-law) employees.

Distributions from a qualified plan are usually fully taxable because most recipients have no cost basis. If you have an investment (cost) in the plan, however, your pension or annuity payments from a qualified plan are taxed under the Simplified Method. For more information about qualified plans, see Publication 560, Retirement Plans for Small Business.

Section 457 deferred compensation plans. If you work for a state or local government or for a tax-exempt organization, you may be able to participate in a section 457 deferred compensation plan. If your plan is an eligible plan, you are not taxed currently on pay that is deferred under the plan or on any earnings from the plan's investment of the deferred pay. You are taxed on amounts deferred in an eligible state or local government plan only when they are distributed from the plan. You are taxed on amounts deferred in an eligible tax-exempt organization plan when they are distributed or otherwise made available to you.

This chapter covers the tax treatment of benefits under eligible section 457 plans, but it does not cover the treatment of deferrals. For information on deferrals under section 457 plans, see Retirement Plan Contributions under Employee Compensation in Publication 525.

For general information on these deferred compensation plans, see Section 457 Deferred Compensation Plans in Publication 575.

Cost (Investment in the Contract)

Before you can figure how much, if any, of a distribution from your pension or annuity plan is taxable, you must determine your cost (your investment in the contract) in the pension or annuity. Your total cost in the plan includes everything that you paid. It also includes amounts your employer paid that were taxable to you when paid. Cost does not include any amounts you deducted or excluded from income.

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 by the later of the annuity starting date or the date on which you received your first payment.

Your annuity starting date is the later of the first day of the first period for which you received a payment, or the date the plan's obligations became fixed.

Your employer or the organization that pays you the benefits (plan administrator) should show your cost in box 5 of your Form 1099-R.

Foreign employment contributions. If you worked in a foreign country and contributions were made to your retirement plan, special rules apply in determining your cost. See Publication 575.

Simplified Method

Under the Simplified Method, you figure the tax-free part of each monthly annuity payment by dividing your cost by the total number of expected monthly payments. For an annuity that is payable for 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 must use the Simplified Method if your annuity starting date is after November 18, 1996, and you receive pension or annuity payments from a qualified plan or annuity, unless you were at least 75 years old and entitled to annuity payments from a qualified plan that are guaranteed for 5 years or more.

Who must use the General Rule. You 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 your annuity payments are guaranteed for at least 5 years.

Annuity starting before November 19, 1996. If your annuity starting date is after July 1, 1986, and before November 19, 1996, you had to use the General Rule for either circumstance described above. You also had to use it for any fixed-period annuity. If you did not have to use the General Rule, you could have chosen to use it. If your annuity starting date is before July 2, 1986, you had to use the General Rule unless you could use the Three-Year Rule.

If you had to use the General Rule (or chose to use it), you must continue to use it each year that you recover your cost.

Who cannot use the General Rule. You cannot use the General Rule if you receive your pension or annuity from a qualified plan and none of the circumstances described in the preceding discussions apply to you. See Who must use the Simplified Method, earlier.

More information. For complete information on using the General Rule, including the actuarial tables you need, see Publication 939.

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.

Exclusion limit. Your annuity starting date determines the total amount that you can exclude from your taxable income over the years.

Exclusion limited to cost. If your annuity starting date is after 1986, the total amount of annuity income that you can exclude over the years as a recovery of the cost cannot exceed your total cost. 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.

Exclusion not limited to cost. If your annuity starting date is before 1987, you can continue to take your monthly exclusion for as long as you receive your annuity. If you chose a joint and survivor annuity, your survivor can continue to take the survivor's exclusion figured as of the annuity starting date. The total exclusion may be more than your cost.

How to use the Simplified Method. Complete the Simplified Method Worksheet in Publication 575 to figure your taxable annuity for 2004. If the annuity is payable only over your life, use your age at the annuity starting date to determine the total number of expected monthly payments for your annuity. For annuity starting dates beginning in 1998, if your annuity is payable over your life and the lives of other individuals, use the combined ages of you and the youngest survivor annuitant at the annuity starting date. However, if your annuity starting date began before January 1, 1998, the total number of monthly annuity payments expected to be received is based on the primary annuitant's age at the annuity starting date.

Be sure to keep a copy of the completed worksheet; it will help you figure your taxable annuity in later years.

Example.

Bill Smith, age 65, began receiving retirement benefits in 2004, under a joint and survivor annuity. Bill's annuity starting date is January 1, 2004. The benefits are to be paid for the joint lives of Bill and his wife Kathy, age 65. Bill had contributed $31,000 to a qualified plan and had received no distributions before the annuity starting date. Bill is to receive a retirement benefit of $1,200 a month, and Kathy is to receive a monthly survivor benefit of $600 upon Bill's death.

Bill must use the Simplified Method to figure his taxable annuity because his payments are from a qualified plan and he is under age 75. Because his annuity is payable over the lives of more than one annuitant, he uses his and Kathy's combined ages and Table 2 at the bottom of the worksheet in completing line 3 of the worksheet. His completed worksheet is shown in Worksheet 11-A.

Bill's tax-free monthly amount is $100 ($31,000 ÷ 310 as shown on line 4 of the worksheet). Upon Bill's death, if Bill 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 Bill 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.

Had Bill's retirement annuity payments been from a nonqualified plan, he would have used the General Rule. He uses the Simplified Method Worksheet because his annuity payments are from a qualified plan.

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 income.

If the retiree was reporting the annuity payments under the General Rule, you must apply the same exclusion percentage to your initial survivor annuity 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.

In any case, if the annuity starting date is after 1986, the total exclusion over the years cannot be more than the cost.

If you are the survivor of an employee, or former employee, who died before becoming entitled to any annuity payments, you must figure the taxable and tax-free parts of your annuity payments using the method that applies as if you were the employee.

Estate tax. If your annuity was a joint and survivor annuity that was included in the decedent's estate, an estate tax may have been paid on it. You can deduct, as a miscellaneous itemized deduction, the part of the total estate tax that was based on the annuity. This deduction is not subject to the 2%-of-adjusted gross-income limit. The deceased annuitant must have died after the annuity starting date. (For details, see section 1.691(d)-1 of the regulations.) This amount cannot be deducted in one year. It must be deducted in equal amounts over your remaining life expectancy.

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.

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.

More than one annuity. 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 Form 1040, line 16a or Form 1040A, line 12a, and enter the taxable part on Form 1040, line 16b, or Form 1040A, line 12b. If all the annuities you receive are fully taxable, enter the total of all of them on Form 1040, line 16b, or Form 1040A, line 12b.

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 Form 1040, line 16a, or Form 1040A, line 12a, and report the taxable part on Form 1040, line 16b, or Form 1040A, line 12b.

Worksheet 11-A. Simplified Method Worksheet for Bill Smith

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 wasbefore 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 below. But if your annuity starting date was after 1997 and the payments are for your life and that of your beneficiary, enter the appropriate number from Table 2 below	3.	310
4.	Divide line 2 by the number on 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.			9.	13,200
	Note: If your Form 1099-R shows a larger taxable amount, use the amount on line 9 instead.
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
	AND your annuity starting date was—
IF the age at 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 older	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 older		210

Lump-Sum Distributions

A lump-sum distribution is the distribution or payment in 1 tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans). A distribution from a nonqualified plan (such as a privately purchased commercial annuity or a section 457 deferred compensation plan of a state or local government or tax-exempt organization) cannot qualify as a lump-sum distribution.

The participant's entire balance from a plan does not include certain forfeited amounts. It also does not include any deductible voluntary employee contributions allowed by the plan after 1981 and before 1987. For more information about distributions that do not qualify as lump-sum distributions, see Distributions that do not qualify under Lump-Sum Distributions in Publication 575.

If you receive a lump-sum distribution from a qualified employee plan or qualified employee annuity and the plan participant was born before January 2, 1936, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify as capital gain subject to a 20% tax rate. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 10-year tax option, discussed later, to figure tax on the ordinary income part.

Use Form 4972 to figure the separate tax on a lump-sum distribution using the optional methods. The tax figured on Form 4972 is added to the regular tax figured on your other income. This may result in a smaller tax than you would pay by including the taxable amount of the distribution as ordinary income in figuring your regular tax.

How to treat the distribution. If you receive a lump-sum distribution, you may have the following options for how you treat the taxable part.

Report the part of the distribution from participation before 1974 as a capital gain (if you qualify) and the part from participation after 1973 as ordinary income.
Report the part of the distribution from participation before 1974 as a capital gain (if you qualify) and use the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).
Use the 10-year tax option to figure the tax on the total taxable amount (if you qualify).
Roll over all or part of the distribution. See Rollovers, later. No tax is currently due on the part rolled over. Report any part not rolled over as ordinary income.
Report the entire taxable part of the distribution as ordinary income on your tax return.

The first three options are explained in the following discussions.

Electing optional lump-sum treatment. You can choose to use the 10-year tax option or capital gain treatment only once after 1986 for any plan participant. If you make this choice, you cannot use either of these optional treatments for any future distributions for the participant.

Taxable and tax-free parts of the distribution. The taxable part of a lump-sum distribution is the employer's contributions and income earned on your account. You may recover your cost in the lump sum and any net unrealized appreciation (NUA) in employer securities tax free.

Cost. In general, your cost is the total of:

The plan participant's nondeductible contributions to the plan,
The plan participant's taxable costs of any life insurance contract distributed,
Any employer contributions that were taxable to the plan participant, and
Repayments of any loans that were taxable to the plan participant.

You must reduce this cost by amounts previously distributed tax free.

Net unrealized appreciation (NUA). The NUA in employer securities (box 6 of Form 1099-R) received as part of a lump-sum distribution is generally tax free until you sell or exchange the securities. (For more information, see Distributions of employer securities under Taxation of Nonperiodic Payments in Publication 575.)

Capital Gain Treatment

Capital gain treatment applies only to the taxable part of a lump-sum distribution resulting from participation in the plan before 1974. The amount treated as capital gain is taxed at a 20% rate. You can elect this treatment only once for any plan participant, and only if the plan participant was born before January 2, 1936.

Complete Part II of Form 4972 to choose the 20% capital gain election. For more information, see Capital Gain Treatment under Lump-Sum Distributions in Publication 575.

10-Year Tax Option

The 10-year tax option is a special formula used to figure a separate tax on the ordinary income part of a lump-sum distribution. You pay the tax only once, for the year in which you receive the distribution, not over the next 10 years. You can elect this treatment only once for any plan participant, and only if the plan participant was born before January 2, 1936.

The ordinary income part of the distribution is the amount shown in box 2a of the Form 1099-R given to you by the payer, minus the amount, if any, shown in box 3. You also can treat the capital gain part of the distribution (box 3 of Form 1099-R) as ordinary income for the 10-year tax option if you do not choose capital gain treatment for that part.

Complete Part III of Form 4972 to choose the 10-year tax option. You must use the special tax rates shown in the instructions for Part III to figure the tax. Publication 575 illustrates how to complete Form 4972 to figure the separate tax.

Rollovers

If you withdraw cash or other assets from a qualified retirement plan in an eligible rollover distribution, you can defer tax on the distribution by rolling it over to another qualified retirement plan or a traditional IRA.

For this purpose, the following plans are qualified retirement plans.

A qualified employee plan.
A qualified employee annuity.
A tax-sheltered annuity plan (403(b) plan).
An eligible state or local government section 457 deferred compensation plan.

You generally must complete the rollover by the 60th day following the day on which you receive the distribution from your employer's plan. (This 60-day period is extended for the period during which the distribution is in a frozen deposit in a financial institution.) For all rollovers to an IRA, you must irrevocably elect rollover treatment by written notice to the trustee or issuer of the IRA.

The IRS may waive the 60-day requirement where the failure to do so would be against equity or good conscience, such as in the event of a casualty, disaster, or other event beyond your reasonable control.

Eligible rollover distributions. Generally, an eligible rollover distribution is any distribution of all or the balance to your credit in a qualified retirement plan. For information about exceptions to eligible rollover distributions, see Publication 575.

Rollover of nontaxable amounts. You may be able to roll over the nontaxable part of a distribution (such as your after-tax contributions) made to another qualified retirement plan or traditional IRA. The transfer must be made either through a direct rollover to a qualified plan that separately accounts for the taxable and nontaxable parts of the rollover or through a rollover to a traditional IRA.

If you roll over only part of a distribution that includes both taxable and nontaxable amounts, the amount you roll over is treated as coming first from the taxable part of the distribution.

Hardship distributions. Hardship distributions are no longer treated as eligible rollover distributions.

Direct rollover option. You can choose to have any part or all of an eligible rollover distribution paid directly to another qualified plan (if permitted) or to a traditional IRA. If you decide on a rollover, it is generally to your advantage to choose this direct rollover option. Under this option, the plan administrator would not withhold tax from any part of the distribution that is directly paid to the other plan.

Withholding tax. If you choose to have all or any part of the distribution paid to you, it is taxable in the year distributed unless you roll it over to another qualified plan or to a traditional IRA within 60 days. The plan administrator must withhold income tax of 20% from the amount of the distribution paid to you. (See Pensions and Annuities under Withholding in chapter 5.)

If you decide to roll over an amount equal to the distribution before withholding, your contribution to the new plan or IRA must include other money (for example, from savings or amounts borrowed) to replace the amount withheld.

The administrator must give you a written explanation of your distribution options within a reasonable period of time before making an eligible rollover distribution.

Rollover by surviving spouse. You may be able to roll over tax free all or part of a distribution from a qualified retirement plan you receive as the surviving spouse of a deceased employee. The rollover rules apply to you as if you were the employee. You can roll over a distribution into a qualified retirement plan or a traditional IRA.

A beneficiary other than the employee's surviving spouse cannot roll over a distribution.

Alternate payee under qualified domestic relations order. You may be able to roll over all or any part of a distribution from a qualified retirement plan that you receive under a qualified domestic relations order (QDRO). If you receive the distribution as an employee's spouse or former spouse (not as a nonspousal beneficiary), the rollover rules apply to you as if you were the employee. You can roll over the distribution from the plan into a traditional IRA or to another eligible retirement plan. See Publication 575 for more information on benefits received under a QDRO.

Retirement bonds. If you redeem a retirement bond purchased under a qualified bond purchase plan, you can defer the tax on the amount received that exceeds your basis by rolling it over to an IRA or qualified employer plan as discussed in Publication 590. For more information on the rules for rolling over distributions, see Publication 575.

Special Additional Taxes

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on early distributions of those funds and on failures to withdraw the funds timely. Ordinarily, you will not be subject to these taxes if you roll over all early distributions you receive, as explained earlier, and begin drawing out the funds at a normal retirement age, in reasonable amounts over your life expectancy. These special additional taxes are the taxes on:

Early distributions, and
Excess accumulation (not receiving minimum distributions).

These taxes are discussed in the following sections.

If you must pay either of these taxes, report them on Form 5329. However, you do not have to file Form 5329 if you owe only the tax on early distributions and your Form 1099-R correctly shows a “1” in box 7. Instead, enter 10% of the taxable part of the distribution on Form 1040, line 59 and write “No” under the heading “Other Taxes” to the left of line 59.

Even if you do not owe any of these taxes, you may have to complete Form 5329 and attach it to your Form 1040. This applies if you meet an exception to the tax on early distributions but box 7 of your Form 1099-R does not indicate an exception.

Tax on Early Distributions

Most distributions (both periodic and nonperiodic) from qualified retirement plans and nonqualified annuity contracts made to you before you reach age 59½ are subject to an additional tax of 10%. This tax applies to the part of the distribution that you must include in gross income.

For this purpose, a qualified retirement plan is:

A qualified employee plan,
A qualified employee annuity plan,
A tax-sheltered annuity plan, or
A state or local government section 457 deferred compensation plan (to the extent that any distribution is attributable to amounts the plan received in a direct transfer or rollover from one of the other plans listed here).

5% rate on certain early distributions from deferred annuity contracts. If an early withdrawal from a deferred annuity is otherwise subject to the 10% additional tax, a 5% rate may apply instead. A 5% rate applies to distributions under a written election providing a specific schedule for the distribution of your interest in the contract if, as of March 1, 1986, you had begun receiving payments under the election. On line 4 of Form 5329, multiply by 5% instead of 10%. Attach an explanation to your return.

Exceptions to tax. Certain early distributions are excepted from the early distribution tax. If the payer knows that an exception applies to your early distribution, distribution code “2,” “3,” or “4” should be shown in box 7 of your Form 1099-R and you do not have to report the distribution on Form 5329. If an exception applies but distribution code “1” (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions.

If distribution code “1” is incorrectly shown on your Form 1099-R for a distribution received when you were age 59½ or older, include that distribution on Form 5329. Enter exception number “11” on line 2.

General exceptions. The tax does not apply to distributions that are:

Made as part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary (if from a qualified retirement plan, the payments must begin after your separation from service),
Made because you are totally and permanently disabled, or
Made on or after the death of the plan participant or contract holder.

Additional exceptions for qualified retirement plans. The tax does not apply to distributions that are:

From a qualified retirement plan (other than an IRA) after your separation from service in or after the year you reached age 55,
From a qualified retirement plan (other than an IRA) to an alternate payee under a qualified domestic relations order,
From a qualified retirement plan to the extent you have deductible medical expenses (medical expenses that exceed 7.5% of your adjusted gross income), whether or not you itemize your deductions for the year,
From an employer plan under a written election that provides a specific schedule for distribution of your entire interest if, as of March 1, 1986, you had separated from service and had begun receiving payments under the election,
From an employee stock ownership plan for dividends on employer securities held by the plan, or
From a qualified retirement plan due to an IRS levy of the plan.

Additional exceptions for nonqualified annuity contracts. The tax does not apply to distributions that are:

From a deferred annuity contract to the extent allocable to investment in the contract before August 14, 1982,
From a deferred annuity contract under a qualified personal injury settlement,
From a deferred annuity contract purchased by your employer upon termination of a qualified employee plan or qualified employee annuity plan and held by your employer until your separation from service, or
From an immediate annuity contract (a single premium contract providing substantially equal annuity payments that start within one year from the date of purchase and are paid at least annually).

Tax on Excess Accumulation

To make sure that most of your retirement benefits are paid to you during your lifetime, rather than to your beneficiaries after your death, the payments that you receive from qualified retirement plans must begin no later than on your required beginning date (defined next). The payments each year cannot be less than the required minimum distribution.

Required beginning date. Unless the rule for 5% owners applies, you must begin to receive distributions from your qualified retirement plan by April 1 of the year that follows the later of:

The calendar year in which you reach age 70½, or
The calendar year in which you retire from employment with the employer maintaining the plan.

However, your plan may require you to begin to receive distributions by April 1 of the year that follows the year in which you reach age 701/, even if you have not retired.

For this purpose, a qualified retirement plan includes a:

Qualified employee plan,
Qualified employee annuity plan,
Section 457 deferred compensation plan, or
Tax-sheltered annuity plan (for benefits accruing after 1986).

Age 70½. You reach age 70½ on the date that is 6 calendar months after the date of your 70th birthday.

For example, if you are retired and your 70th birthday was on June 30, 2004, you were age 70½ on December 30, 2004. If your 70th birthday was on July 1, 2004, you reached age 70½ on January 1, 2005.

5% owners. If you are a 5% owner of the company maintaining your qualified retirement plan, you must begin to receive distributions by April 1 of the calendar year that follows the year in which you reach age 70½, regardless of when you retire.

Required distributions. By the required beginning date, as explained earlier, you must either:

Receive your entire interest in the plan (for a tax-sheltered annuity, your entire benefit accruing after 1986), or
Begin receiving periodic distributions in annual amounts calculated to distribute your entire interest (for a tax-sheltered annuity, your entire benefit accruing after 1986) over your life or life expectancy or over the joint lives or joint life expectancies of you and a designated beneficiary (or over a shorter period).

Additional information. For more information on this rule, see Tax on Excess Accumulation in Publication 575.

Required distributions not made. If the actual distributions to you in any year are less than the required minimum distribution, you are subject to an additional excise tax. The tax equals 50% of the part of the required minimum distribution that was not distributed. You can get this excise tax waived if you establish that the shortfall in distributions was due to reasonable error and that you are taking reasonable steps to remedy the shortfall.

State insurer delinquency proceedings. You might not receive the minimum distribution because of state insurer delinquency proceedings for an insurance company. If your payments are reduced below the minimum due to these proceedings, you should contact your plan administrator. Under certain conditions, you will not have to pay the excise tax.

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 Pensions

If you retired on disability, you generally must include in income any disability pension you receive under a plan that is paid for by your employer. You must report your taxable disability payments as wages on line 7 of Form 1040 or Form 1040A until you reach minimum retirement age. Minimum retirement age generally is the age at which you can first receive a pension or annuity if you are not disabled.

You may be entitled to a tax credit if you were permanently and totally disabled when you retired. For information on this credit, see chapter 35.

Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension or annuity. Report the payments on Form 1040, lines 16a and 16b or on Form 1040A, lines 12a and 12b.

Disability payments for injuries incurred as a direct result of a terrorist attack directed against the United States (or its allies) are not included in income. For more information about payments to survivors of terrorist attacks, see Publication 3920, Tax Relief for Victims of Terrorist Attacks.

For more information on how to report disability pensions, including military and certain government disability pensions, see chapter 6.

Purchased Annuities

If you receive pension or annuity payments from a privately purchased annuity contract from a commercial organization, such as an insurance company, you generally must use the General Rule to figure the tax-free part of each annuity payment. For more information about the General Rule, get Publication 939. Also, see Variable Annuities in Publication 575 for the special provisions that apply to these annuity contracts.

Sale of annuity. Gain on the exchange of an annuity contract is ordinary income to the extent that the gain is due to interest accumulated on the contract and the exchange is for a life insurance or endowment contract. You do not r