One of the more confusing issues addressed in tax education for the certified public accountant exam is pension and annuity income. Taxpayers are often perplexed about the tax treatment of these payments. Some people may even request an explanation of the tax implications – especially if the pension or annuity causes them to owe income tax. Every CPA must prepare for rendering these descriptions.
Payments from a pension or annuity almost always incur income tax. The specific taxable part depends upon factors described in CPA examination materials. Entire amounts received from a pension or annuity are taxed for individuals who made no contributions to the arrangements.
Contributed amounts comprise a basis in the contract. Therefore, people may have basis as a result of their payments into a pension plan or premiums paid for an annuity contract. Distributions of basis are not taxable. But other disbursed amounts – such as income accumulated within the plan – are taxed upon distribution.
Understanding basis is the key element about pension and annuity income in CPA books. The topic of basis is also the most complicated concept for taxpayers to comprehend. On occasion, employers withhold from wages of workers their contributions to pension or annuity plans. Contributions of after-tax money add to basis. However, contributing funds withheld from pay before tax is determined does not create basis. Since these amounts were never taxed as wages, they are taxable income when withdrawn from the pension or annuity plan.
When a taxpayer has basis in a pension or annuity, distributions contain both taxable and nontaxable amounts. An entire pension or annuity withdrawal is never treated as completely comprising a return of basis. Instead, the percent of taxable amount is calculated. Determining the taxable component necessitates following the same process entailed in answering a practice CPA exam question about this topic.
Partially taxable pensions and annuities are determined by applying either the General Rule or the Simplified Method. For plans with payments that began after November 18, 1986, the Simplified Method always applies. A CPA exam study guide explains that this calculation computes the taxable part of a pension or annuity by using the ratio of basis to total contract value. For a plan with lifetime payments, the contract value is based upon annual payments and the recipient’s age.
Individuals are expected to obtain pension and annuity disbursements after retirement age. Withdrawals before reaching age 59½ usually incur a penalty of 10 percent for early distribution. The penalty is only applied to the taxable component of payments. Exceptions apply for individuals who become disabled or take sustained equal periodic payments.
IRS Circular 230 Disclosure
Pursuant to the requirements of the Internal Revenue Service Circular 230, we inform you that, to the extent any advice relating to a Federal tax issue is contained in this communication, including in any attachments, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.