Publication 575, Pension and Annuity Income: Cost Basis and Methods

IRS Publication 575 explains how to tax pension and annuity income by splitting each payment into two parts: a tax-free return of the money you already paid tax on, and a taxable remainder that gets reported as ordinary income. For most retirees drawing a periodic pension from an employer plan, the split is calculated with the Simplified Method. For most commercial annuities and other non-qualified contracts, it’s calculated with the General Rule. The mechanics of both come down to one input you have to know first: your cost basis.

Your Cost Basis in the Contract

Cost basis, which the IRS calls your “investment in the contract,” is the total amount you put into the plan with money that had already been taxed. After-tax payroll contributions to a pension fund are the typical example. The IRS lets you recover that money tax-free across the life of your payments.

Employer contributions generally do not count toward your cost basis unless they were reported as taxable income to you when they were made. Your basis is sometimes shown in Box 9b of Form 1099-R, but not every payer fills it in, so your own records matter. Once you have the number, the rest is mechanical: spread it across your expected payments to find the tax-free piece, and whatever is left in each payment is taxable at ordinary income rates.

The Simplified Method

Most retirees use the Simplified Method. It applies to periodic payments from qualified employer plans, government pensions, 403(b) plans, and qualified employee annuities when the annuity starting date falls after November 18, 1996. For annuities that began between July 2, 1986, and November 19, 1996, you could elect either the Simplified Method or the General Rule, and that choice was permanent.

How the Math Works

Divide your total cost basis by a set number of expected monthly payments from an IRS table. The result is a fixed dollar amount excluded from every payment as a tax-free return of your investment. That exclusion stays the same each month until you have recovered your entire cost basis.

For a single-life annuity starting after November 18, 1996, the expected payment numbers come from this table:

Age 55 or under: 360 payments
Age 56–60: 310 payments
Age 61–65: 260 payments
Age 66–70: 210 payments
Age 71 or older: 160 payments

For a joint-and-survivor annuity, a separate table uses the combined ages of both annuitants. Combined ages of 131–140, for example, use 260 expected payments, and combined ages of 110 or under use 410 payments.¹

A Worked Example

You retire at 67 with a cost basis of $63,000 and a monthly pension of $2,500. At 67, the table gives you 210 expected monthly payments. Divide $63,000 by 210 and your tax-free exclusion is $300 per month. Of each $2,500 check, $300 is nontaxable and $2,200 is ordinary income. You exclude $300 a month until you have recovered the full $63,000, which takes exactly 210 months (17.5 years) if you receive every payment on schedule.

Live past that point and every subsequent payment is fully taxable. Die before recovering the full cost basis and the unrecovered amount is allowed as an itemized deduction on your final tax return.¹ That deduction is not a miscellaneous itemized deduction subject to the 2% AGI floor, so it remains available even under current rules that suspended most miscellaneous deductions.

The General Rule

The General Rule is a more involved actuarial calculation used mainly for non-qualified annuities, including commercial annuities you bought from an insurance company and payments from a non-qualified employer plan. It also applies in limited qualified-plan situations: when the annuity starting date was before November 19, 1996 and the taxpayer did not elect the Simplified Method, or when the starting date is after November 18, 1996, the annuitant was 75 or older, and payments are guaranteed for at least five years.²

The Exclusion Ratio

Instead of a fixed dollar exclusion, the General Rule produces a percentage called the exclusion ratio. You get it by dividing your cost basis by the expected return under the contract. The expected return is the total amount you are anticipated to receive over the life of the annuity, computed using actuarial tables prescribed by the IRS under Internal Revenue Code Section 72.³

If your cost basis is $15,000 and the expected return is $100,000, your exclusion ratio is 15%. Fifteen percent of every payment is a tax-free return of your investment and the remaining 85% is ordinary income.

When the Exclusion Ends

For annuities with a starting date after 1986, the exclusion stops once you have recovered your full net cost. After that, every payment is entirely taxable. If your net cost is $10,000 and your exclusion ratio produces a $100 monthly exclusion, the exclusion ends after 100 months regardless of whether payments keep coming.² As with the Simplified Method, any unrecovered cost at death is deductible on the final return.

Insurance companies and plan administrators often compute the expected return and exclusion ratio for you. If yours has not, Publication 939 walks through the actuarial tables step by step, but the calculation is intricate enough that professional help is often worth it.

Reporting the Numbers on Form 1040

Your plan administrator or insurance company sends you a Form 1099-R each January. Box 1 shows the gross distribution. Box 2a shows the taxable amount the payer calculated. If Box 2a is filled in, you can generally use that figure directly. If it is blank or says “Taxable amount not determined,” you need to run the Simplified Method or General Rule yourself.⁴

On Form 1040, enter the gross distribution from Box 1 on Line 5a and the taxable amount on Line 5b. Even when the payer provided a taxable amount in Box 2a, you are allowed to report a lower figure if your own calculation produces one.⁴

When the 1099-R Is Wrong

Payers sometimes report an incorrect taxable amount in Box 2a. Contact the payer first for a corrected form. If you still have not received a corrected 1099-R by the end of February, call the IRS at 800-829-1040 and they will contact the payer on your behalf. You can file in the meantime using Form 4852 as a substitute, estimating the correct figures. If a corrected 1099-R arrives after you file and the numbers differ from your estimates, file an amended return on Form 1040-X.⁵

Withholding and Estimated Tax

Pension payers withhold federal income tax from periodic payments unless you opt out by submitting Form W-4P. The form was redesigned in 2022 and no longer uses the old allowance system. If you start receiving payments and don’t submit a W-4P, the default withholding is calculated as if you are a single filer with no other adjustments, which often means more tax is withheld than necessary for married retirees or those with lower income.⁶

Non-periodic payments like lump-sum distributions that are not directly rolled over are subject to mandatory 20% federal income tax withholding. You cannot opt out. The only way around it is a direct rollover, where the funds move straight from one plan to another without being paid to you.⁷

If withholding doesn’t cover your full tax bill, you may owe quarterly estimated tax using Form 1040-ES. The IRS generally expects estimated payments when you owe at least $1,000 after subtracting withholding and refundable credits, and your withholding covers less than 90% of the current year’s tax or 100% of the prior year’s tax (110% if your prior-year AGI exceeded $150,000).⁸

Retired Public Safety Officer Exclusion

Retired law enforcement officers, firefighters, chaplains, and members of a rescue squad or ambulance crew can exclude up to $3,000 per year from pension income if the money is used to pay health or long-term care insurance premiums. The distribution must come from a governmental retirement plan maintained by the employer you retired from, and the premiums must cover you, your spouse, or your dependents.⁹

The exclusion only applies to amounts that would otherwise be included in income, and you cannot also claim the same premiums as a medical expense deduction. You elect it by reducing the taxable amount reported on Line 5b.

Disability Pension Payments

Disability payments from a pension plan are treated differently depending on your age. If you receive disability retirement payments before you reach the plan’s minimum retirement age, those payments may be reported as wages rather than pension income, and they could qualify for exclusion if you are permanently and totally disabled. That determination requires a physician’s certification.

Once you reach the minimum retirement age (the earliest age you would have been eligible for a regular pension had you not been disabled), the payments switch to pension income and the Simplified Method or General Rule calculations apply going forward. The minimum retirement age is not the same as 59½ or Social Security’s full retirement age; it is specific to your employer’s plan.

Survivor and Beneficiary Payments

When an annuitant dies, the tax treatment of payments to a beneficiary depends on the type of benefit. If a beneficiary receives a lump-sum death benefit that fully satisfies the plan’s obligation, the beneficiary can exclude the decedent’s remaining unrecovered cost basis from income. Only the amount exceeding that basis is taxable.¹

Under a joint-and-survivor annuity, the surviving annuitant generally continues receiving periodic payments and steps into the cost basis recovery already in progress. Any portion of the survivor annuity that qualifies as income in respect of a decedent may also carry an estate tax deduction under IRC Section 691(c), which can offset some of the income tax owed on those payments.

If the original annuitant died before the annuity starting date and the beneficiary receives a death benefit from a deferred annuity contract, only the amount exceeding the decedent’s cost basis is included in the beneficiary’s income.¹

A Note on State Taxes

Publication 575 governs federal tax only. State treatment of pension and annuity income varies widely: some states have no income tax, some fully exempt pension income, some offer partial exclusions tied to age or income, and some tax it the same way the federal government does. If you are weighing a move in retirement, check your state’s department of revenue for current rules, because these change often and the dollar impact can be significant.

1
Internal Revenue Service. Publication 575 (2025), Pension and Annuity Income
2
Internal Revenue Service. Publication 939 (12/2025), General Rule for Pensions and Annuities
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Instructions for Form 1040 and 1040-SR – Section: Lines 5a, 5b, and 5c
5
Internal Revenue Service. Topic No. 154, Form W-2 and Form 1099-R (What to Do if Incorrect or Not Received)
6
Internal Revenue Service. 2026 Form W-4P Withholding Certificate for Periodic Pension or Annuity Payments
7
eCFR. 26 CFR 31.3405(c)-1 – Withholding on Eligible Rollover Distributions
8
Internal Revenue Service. Estimated Tax
9
Internal Revenue Service. Publication 575, Pension and Annuity Income