Publication 575, Pension and Annuity Income: Cost Basis Methods

IRS Publication 575, Pension and Annuity Income, splits every periodic payment you receive into two pieces: a tax-free return of the money you already paid tax on, and a taxable portion that’s ordinary income. To find the split, you use one of two methods — the Simplified Method for most employer pensions, or the General Rule for most commercial annuities and a narrow set of older or older-annuitant qualified plans.

Start With Your Cost Basis

Publication 575 calls it your “investment in the contract.” It’s the total you contributed with money that had already been taxed. After-tax payroll contributions to a pension count. Employer contributions generally do not, unless they were reported as taxable income to you when they were made.

Your cost basis is sometimes shown in Box 9b of Form 1099-R, but not every payer fills that box in, so your own records matter. Once you know the number, the rest is mechanical: spread the basis across your expected payments to find the tax-free piece, and everything above that piece 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 with an annuity starting date after November 18, 1996. For annuities that started between July 2, 1986 and November 19, 1996, you could elect either the Simplified Method or the General Rule, and that election 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 each payment as a tax-free return of your investment. That exclusion stays the same every month until you’ve recovered your entire cost basis.

For a single-life annuity starting after November 18, 1996, the age of the annuitant on the starting date sets the number of expected payments:

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

A joint-and-survivor annuity uses a separate table keyed to the combined ages of both annuitants. Combined ages of 131–140, for example, use 260 expected payments; combined ages of 110 or under use 410.¹

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 monthly exclusion is $300. Of your $2,500 check, $300 is nontaxable and $2,200 is ordinary income. You keep excluding $300 each month until you’ve recovered the full $63,000, which takes exactly 210 months if you receive every payment.

Live past that point and every later payment is fully taxable. Die before recovering the full basis and the unrecovered amount is allowed as an itemized deduction on the final tax return.¹ Publication 575 treats this deduction as outside the 2% AGI floor for miscellaneous deductions, so it remains available even under current rules that suspended most miscellaneous deductions.

The General Rule

The General Rule is a more complex actuarial calculation used primarily for non-qualified annuities, such as commercial annuities purchased from an insurance company or payments from a non-qualified employer plan. It also applies to some qualified plans: when the annuity starting date was before November 19, 1996 and the taxpayer didn’t 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

Calculating the Exclusion Ratio

Instead of a fixed dollar exclusion, the General Rule produces a percentage. Divide your cost basis by the expected return under the contract. The expected return is the total amount you’re 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 investment; the remaining 85% is ordinary income.

When the Exclusion Ends

For annuities with a starting date after 1986, the exclusion stops once you’ve recovered your full net cost. Every payment after that is entirely taxable. If your net cost is $10,000 and the exclusion ratio produces a $100 monthly exclusion, the exclusion ends after 100 months regardless of how long payments continue.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 the exclusion ratio for you. If yours hasn’t, Publication 939 walks through the actuarial tables step by step, though the calculation can be tricky enough to justify professional help.

Which Method Applies to You

Use the Simplified Method if you receive periodic payments from a qualified employer plan, a government pension, a 403(b), or a qualified employee annuity with a starting date after November 18, 1996. Use the General Rule for a non-qualified commercial annuity, a non-qualified employer plan, or the narrow qualified-plan situations above (pre-November 19, 1996 start with no Simplified Method election, or a starting date after that date with an annuitant age 75+ and at least five years of guaranteed payments). If your annuity started between July 2, 1986 and November 19, 1996, whichever method you elected at the time controls.

Reporting on Your Tax Return

Your plan administrator or insurance company sends you Form 1099-R each January. Box 1 shows the gross distribution. Box 2a shows the taxable amount the payer calculated. If the payer determined a taxable amount, you can generally use that figure. If Box 2a is blank or says “Taxable amount not determined,” you 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 if the payer filled in Box 2a, you can report a lower figure on Line 5b if your own calculation produces one.⁴

When Your Form 1099-R Is Wrong

Payers sometimes report an incorrect taxable amount in Box 2a. Contact the payer first and ask for a corrected form. If you still don’t have one by the end of February, call the IRS at 800-829-1040 and they’ll contact the payer for you. In the meantime you can file 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 on Periodic Payments

Pension payers withhold federal income tax from your periodic payments unless you opt out on 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 treats you as a single filer with no other adjustments, which often withholds more than a married retiree or a lower-income retiree actually owes.⁶

If withholding from your pension doesn’t cover your total tax liability, you may need quarterly estimated payments on Form 1040-ES. The IRS generally expects estimated tax when you’d 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).⁷

Traditional IRAs Are Not Covered by These Methods

The Simplified Method and General Rule don’t apply to traditional IRA distributions. If all your IRA contributions were tax-deductible, the entire distribution is ordinary income and there’s no basis to recover. If you made non-deductible contributions, you can’t just pull out the non-deductible part. The IRS treats all of your traditional IRAs (including SEP and SIMPLE IRAs) as a single combined account and applies a pro-rata calculation. If your combined IRA balances total $200,000 and $40,000 of that is non-deductible contributions, 20% of any distribution is tax-free and 80% is taxable, no matter which account you actually draw from. You track the basis on Form 8606 every year you take a distribution.⁸

Retired Public Safety Officer Exclusion

A retired law enforcement officer, firefighter, chaplain, or member 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 has to come from a governmental retirement plan maintained by the employer you retired from, and the premiums have to cover you, your spouse, or your dependents.⁹

The exclusion only reaches amounts that would otherwise be included in income, and you can’t also claim those same premiums as a medical expense deduction. You elect it when filing 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. Received before you reach the plan’s minimum retirement age, they may be reported as wages rather than pension income, and they can qualify for exclusion if you’re permanently and totally disabled. That 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 become pension income and the Simplified Method or General Rule applies going forward. The minimum retirement age isn’t 59½, and it isn’t Social Security’s full retirement age. It’s specific to your employer’s plan.

Payments to Beneficiaries and Survivors

When an annuitant dies, the tax treatment of payments to a beneficiary depends on the 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 above that basis is taxable.¹

Under a joint-and-survivor annuity, the surviving annuitant 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

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
Internal Revenue Service. Estimated Tax
8
Internal Revenue Service. Instructions for Form 8606 (2025)
9
Internal Revenue Service. Publication 575, Pension and Annuity Income