How annuity income is taxed: exclusion ratio, qualified vs. non-qualified, and what to enter in a plan

An annuity or pension payment is one number on your statement and up to three different tax answers. The payment can be fully taxable, partly taxable, or (rarely) not taxable at all, and the answer depends on how the money went in, not on how it comes out. Runway's Other Income step has a Taxable portion field for exactly this reason. This guide explains what the IRS rules say, how to find your number, and what happens to a plan when it's wrong.

Why does the way I paid for it change the tax?

Income tax is meant to apply once. Money that was already taxed when you earned it shouldn't be taxed again when it comes back to you. The IRS puts it this way in Topic 410, Pensions and Annuities: "You won't pay tax on the part of the payment that represents a return of the after-tax amount you paid." The amount you put in with after-tax dollars is your investment in the contract (also called your cost or basis). Whatever the payments return beyond that cost is earnings, and earnings are taxable. If nothing you put in was after-tax, as with a traditional IRA or a 401(k) funded by payroll deferrals, there is no cost to recover and the whole payment is taxable.

How does the Simplified Method split a payment?

For payments from a qualified plan, the IRS tells you to use its Simplified Method; its Topic 411 says you use it when you "begin receiving annuity payments from a qualified retirement plan" and complete the Simplified Method Worksheet in the Form 1040 instructions or in Publication 575. The arithmetic is one division: the tax-free amount of each monthly payment is your cost divided by the number of expected monthly payments, which Publication 575 sets by your age on the day payments start (for annuities starting after November 18, 1996):

Take a $200,000 after-tax cost and a payment of $1,300 a month starting at 66. That is 210 expected payments, so $200,000 ÷ 210 = $952.38 of each payment is tax-free and the other $347.62 (26.7%) is taxable. The tax-free amount stays the same every month until you have recovered your whole cost, after 210 payments, or 17½ years. From then on, Publication 575 says all further payments are generally fully taxable. The share that is tax-free is a fixed dollar amount, so as a percentage of the payment it only changes when the payment itself changes.

A commercial annuity you bought with after-tax money uses the General Rule instead. Per Publication 939, the General Rule is for non-qualified plans such as a purchased commercial annuity. Its exclusion percentage is your investment in the contract divided by your expected return, which comes from IRS life-expectancy tables. You rarely do that arithmetic by hand: the payer reports your payments on Form 1099-R and, when it can work out the taxable amount, shows it there.

What does it cost to get the taxable percentage wrong?

Runway's default for an annuity is 100% taxable. That is deliberate: overstating tax is the safer mistake, and most annuities held in retirement accounts are fully taxable. But for an after-tax annuity it's too high. To measure how much, take the sample couple Runway loads (Pat 65, Alex 64, $1.46 million across five accounts, $95,000 of spending) and add the $15,600-a-year annuity from the example, starting when Pat is 66. The Simplified Method treatment is 26.7% taxable through age 82 and 100% from 83 (the engine works in whole years, so the last half-year of cost recovery is rounded).

Leaving the default in place adds $20,838 of tax that the plan will never actually pay. The difference arrives gradually: the couple owes $0 either way at 66 and 70, but at 75 their federal tax is $9,401 with the split and $10,766 at 100% taxable. Over a 30-year plan it adds up, and the extra tax has to be paid from the couple's other accounts.

What should I enter in Runway?

1. On the Other Income step, add the income as an Annuity (or Pension), and enter the full payout you receive per year. The whole payment is spendable either way; the Taxable portion only controls how much is taxed.
2. Leave Taxable portion blank for 100% if the money was pre-tax. Otherwise enter the percentage from your Form 1099-R or your own worksheet. In the example that is 26.7%.
3. Set Starts at age. Runway uses one fixed percentage for the whole time, so to show the step-up after your cost is recovered, enter two lines: one at the partial percentage that ends at the age cost recovery finishes, and one at 100% that starts after it.

What does this leave out?

• One fixed percentage at a time. The engine doesn't track your cost payment by payment; you describe the split, and it applies it.
• Inflation. Runway shows every amount in today's dollars, so a $15,600 line is treated as keeping its buying power. Many annuities pay a fixed amount that loses purchasing power over time; lower the amount you enter if yours doesn't adjust for inflation.
• Survivor payments, period-certain guarantees, and unrecovered cost at death each have their own rules in Publication 575 and aren't modeled.
• Non-periodic withdrawals from a deferred annuity (cashing out part of the contract) follow different ordering rules than annuity payments and aren't covered here.
• State tax and Social Security. The engine does count taxable annuity income when it tests how much of your Social Security is taxable, which is part of why the taxable portion matters.

How were these numbers computed?

Every tax figure comes from Runway's planning engine on the sample household, married filing jointly, plan through age 95, 2026 federal brackets, with the long-term-care cost left out. The annuity is $1,300 a month ($15,600 a year) starting at Pat's age 66; the Simplified Method amounts come from the IRS table above. Lifetime tax is the sum of the engine's projected federal tax over every year of the plan, in today's dollars. The engine check that reproduces them is in the project's drafts folder.