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Page 8 of 85 Fileid: … ons/p939/202212/a/xml/cycle03/source 17:28 - 10-Mar-2023
The type and rule above prints on all proofs including departmental reproduction proofs. MUST be removed before printing.
In the first year of your annuity, your first payment $324 (18.0% × $1,800) of each of your childrens' pay-
TIP or part of your first payment may be for a fraction ments will be tax free and each must include the balance,
of the payment period. This fractional amount is $1,476, as income on their own income tax return.
multiplied by your exclusion percentage to get the tax-free
part. Part-year payments. If you receive payments for only
part of a year, apply the exclusion percentage to the first
regular periodic payment, and multiply the result by the
Step 6. Subtract the tax-free part from the total payment
number of payments received during the year.
you received. The rest is the taxable part of your pension
If you receive amounts during the year that represent
or annuity.
12 payments, one for each month in that year, and an
Example 1. You purchased an annuity with an invest- amount that represents payments for months in a prior
ment in the contract of $10,800. Under its terms, the annu- year, apply the exclusion percentage to the first regular
ity will pay you $100 a month for life. The multiple for your periodic payment, and multiply the result by the number of
age (age 65) is 20.0 as shown in Table V. Your expected payments the amounts received represent. For instance, if
return is $24,000 (20 × 12 × $100). Your cost of $10,800, you received amounts during the year that represent the
divided by your expected return of $24,000, equals 12 payments for that year plus an amount that represents
45.0%. This is the percentage you won't have to include in three payments for a prior year, multiply that amount by
income. the 15 (12 + 3) payments received that year.
Each year, until your net cost is recovered, $540 (45% If you received a fractional payment, follow Step 5, dis-
of $1,200) will be tax free and you will include $660 cussed earlier. This gives you the tax-free part of your to-
($1,200 − $540) in your income. If you had received only tal payment.
six payments of $100 ($600) during the year, your exclu-
Example. On September 28, Mary bought an annuity
sion would have been $270 (45% of $100 × 6 payments).
contract for $22,050 that will give her $125 a month for
Example 2. Gerald bought a joint and survivor annuity. life, beginning October 30. The applicable multiple from
Gerald's investment in the contract is $62,712 and the ex- Table V is 23.3 (age 61). Her expected return is $34,950
pected return is $121,200. The exclusion percentage is ($125 × 12 × 23.3). Mary's investment in the contract of
51.7% ($62,712 ÷ $121,200). Gerald will receive $500 a $22,050, divided by her expected return of $34,950,
month ($6,000 a year). Each year, until his net cost is re- equals 63.1%. Each payment received will consist of
covered, $3,102 (51.7% of his total payments received of 63.1% return of cost and 36.9% taxable income, until her
$6,000) will be tax free and $2,898 ($6,000 − $3,102) will net cost of the contract is fully recovered. During the first
be included in his income. If Gerald dies, his spouse will year, Mary received three payments of $125, or $375, of
receive $350 a month ($4,200 a year). If Gerald hadn't re- which $236.63 (63.1% × $375) is a return of cost. The re-
covered all of his net cost before his death, his spouse will maining $138.37 is included in income.
use the same exclusion percentage (51.7%). Each year,
Increase in annuity payments. The tax-free amount re-
until the entire net cost is recovered, his spouse will re-
mains the same as the amount figured at the annuity start-
ceive $2,171.40 (51.7% of the spouse’s payments re-
ing date, even if the payment increases. All increases in
ceived of $4,200) tax free. The spouse will include
the installment payments are fully taxable.
$2,028.60 ($4,200 − $2,171.40) on the income tax return.
However, if your annuity payments are scheduled to in-
Example 3. Using the same facts as Example 2, ear- crease at a definite date in the future, you must figure the
lier under Different payments to survivor, you are to re- expected return for that annuity using the method descri-
ceive an annual annuity of $4,800 until you die or remarry. bed in section 1.72-5(a)(5) of the regulations.
Your two children each receive annual annuities of $1,800
Example. Joe's spouse died while still employed and,
until they reach age 18. Your spouse contributed $25,576
as the beneficiary, he began receiving an annuity of $147
to the plan. You are eligible for the $5,000 death benefit
per month. In figuring the taxable part, Joe elects to use
exclusion because your spouse died before August 21,
Tables V through VIII. The cost of the contract was
1996.
$7,938, consisting of the sum of his spouse's net contribu-
Adjusted Investment in the Contract tions, adjusted for any refund feature. His expected return
as of the annuity starting date is $35,280 (age 65, multiple
Contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . $25,576 of 20.0 × $1,764 annual payment). The exclusion percent-
Plus: Death benefit exclusion . . . . . . . . . . . . . . . . . . . 5,000 age is $7,938 ÷ $35,280, or 22.5%. During the year, he re-
Adjusted investment in the contract. . . . . . . . . . . . . . . $30,576 ceived 11 monthly payments of $147, or $1,617. Of this
amount, 22.5% × $147 × 11 ($363.83) is tax free as a re-
The total expected return, as previously figured (in Ex- turn of cost and the balance of $1,253.17 is taxable.
ample 2 under Different payments to survivor), is Later, because of a cost-of-living increase, his annuity
$169,680. The exclusion percentage of 18.0% ($30,576 ÷ payment was increased to $166 per month, or $1,992 a
$169,680) applies to the annuity payments you and each year (12 × $166). The tax-free part is still only 22.5% of
of your children receive. Each full year, $864 (18.0% × the annuity payments as of the annuity starting date
$4,800) will be tax free to you, and you must include
$3,936 in your income tax return. Each year, until age 18,
Page 8 Publication 939 (December 2022)
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