 Hello and welcome to this session in which we will discuss the taxability of pensions and annuities. Let's talk about pensions first. What is a pension? Well, when you work for a company for a period of time, and this used to be very common back in the 60s, 70s and early 80s, what would happen if you work for a company for 20 years or 30 years? And what they do after you work for this company are going to retire. And what would happen after you retire, the company will keep making payments for you. Why? Because you service the company over a period of time. Now pensions are still common for governmental jobs. If you're a police officer, a firefighters, teachers, they do still have retire pensions as a retirement option. So what is a pension? Pensions are series of payments made to the taxpayer after he or she retires from work. These payments are determined based on the taxpayer years of service and prior compensation. Now how much do you get paid? If you have a retirement plan, there is a formula under retirement plan, each individual will get paid differently based on the actuarial assumptions. But you'll get the more, obviously the more time you put into your work, the more you would receive the higher your salary, the higher is your pension amount. Now pension plans may be contributory where the taxpayers makes contribution to the plan while being an employee or non-contributory. So you have to understand the difference between the two. Let's start with non-contributory. Non-contributory means you as an employee, you invested $0. You don't have to worry about contributing any money to the pension plan. Why? Because your company, the company that you work for, your employer will contribute all the money. So it's free to you. Or the plan could be contributory. Contributory means, well, the company pays an amount and you also have an amount deducted from your paycheck. Most pension plans now, if they still exist, they're contributory because it's more expensive for the company to have a non-contributory plan. Non-contributory means you don't have to pay anything. So let's start with the taxability of non-contributory plan because it's easy to deal with. If it's a non-contributory plans, when you start to take this money out, when you retire, all the withdrawals should be included in your gross income. Why? Because you have nothing invested. You don't have any money invested in the plan. Everything that you receive is income and that income is taxable. So it's easy. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. How about if it's a contributory plan? Contributory plan means you put some money and the company contributed the other. In a contributory plan, the amounts withdrawn by the taxpayer after retirement are as follows. Well, recovery of the employee contribution are executed and we should notice this is considered the return of capital. They're giving you back the money that you contributed. Recovery of employer's contribution, employers now, which is the company, so this is the company contribution. Guess what? The company contribution is taxable to you, are included in your income. Now withdrawal and access of total contribution, if you're still taking money in access of the contribution, everything becomes taxable, of course, because you did not contribute anything. Let's look at the form where information is being reported. Usually when you have an annuity or a pension, you'll receive a 1099R. They will tell you the gross distribution, how much you receive, how much of it is taxable, if there's anything deducted for federal taxes. On your income tax, form 1040, you would receive, there's a line 5A. Now this could change in a separate year, it doesn't really matter. Some of the pension is non-taxable, some of it is taxable. Same thing with annuities, some of it is taxable, some of it is non-taxable. Now let's talk about annuities. Annuities in concept are similar to pensions, but they are different. Why? Because remember, a pension is the assumption is you work for someone, you work for a company and the company have the pension plan. Annuities are a little bit different. Annuities is when the individual, they invest themselves and they want to receive an annuity. What is an annuity? Same thing, a series of payments. This is what an annuity is. When you should be familiar with the term annuity, because you need to understand how leases work, bonds, any payment for the same amount at the same interval is called an annuity. So usually what happens is this, once you get close to retirement, let's assume you want to retire at age 65. What people usually do, they sell their stocks, they sell their bonds, they sell all their investments and they take their money. Let's assume they have half a million invested and what they do, they purchase an annuity because they don't want to worry about the stock market, the investments, the bond going up or down. They want to receive a certain amount of money every month or every year guaranteed. So this is what annuity is. They will take this money, half a million, they will give it to an insurance company and they will purchase an investment and this investment will start to pay them. For example, every year, let's assume they want $50,000 and for example, they want to do it for 20 years or whatever the amount is just giving you an example. So typically annuities are issued by insurance companies, typically, but you can buy them from any investment firm. The purchaser of the annuity invests the money, an amount of money for the right to receive a future stream of payments. The payments can be made over a fixed period of time so the annuity could be for example for 20 years or you can buy an annuity forever. Forever means it will keep paying you forever. Obviously there's a different cost for each annuity but the point is sometimes you don't know how long you're going to live. Sometimes you might say, let me buy it for 20 years and I do have other income where I can bring in after 20 years and it will help me survive the remaining 20 years and sometimes you would say, I just want to buy a lifetime annuity, I may live five years, I may live another 30 years, I don't know, so you can either buy either or. So the insurance company would typically invest the money received from the purchaser and generate income. We call it cash value, cash value accumulates because that's the purpose you gave them the money is to generate revenue for you and give you some of that revenue and principle for you to live off. However, the purchaser of the annuity does not have any obligation of interest income because that's considered interest until he or she starts collecting the payment. So as the annuity generates cash value, you're not taxed until you receive the money. Now in general, each payment made to the purchaser of the annuity consists of principle amount, which represent obviously non-taxable, the principle is return of capital, return of capital, and an interest component. The interest component, the return, is the taxable amount and we're going to look at different scenarios. In case of a lifetime annuity, what's a lifetime annuity? Well, you buy it and you receive a payment forever. The principle amount obviously is non-taxable is computed by dividing the initial amount invested, which is the investment by a life expectancy factor determined using the IRS life expectancy table. We'll look at an example of course, but this is how you do it. Now, if the taxpayer dies before the end of his expected life, any unrecovered investment is deductible on the taxpayer local last income tax return. So if you die before recovering all your capital, all the money that you invested, then that amount is deductible on your last income tax return. You get a deduction for that. However, if he or she lives more than the expected, the payment received after the end of the expected life becomes taxable in its entirety. So let's assume you invested half a million and you outlive your received more payments than a half a million. Then if that's the case, you return your capital, everything now is taxable. In case of a fixed period annuity payment, fixed period means you buy it for 10 to 15 years. The principle amount is computed by dividing the initial investment by the number of payments to be made. Don't worry, we're going to look at an example at a lifetime annuity, as well as a fixed period annuity. Now, what happened if you have an early withdrawal? If the purchase of an annuity decides to withdraw a given amount from an annuity, what would happen? So simply put you put your money, then you change your mind. You said, you know what? I'm going to need this money. Well, the amount withdrawn, if the amount withdrawn is less than the original amount, guess what? If it's less, it's non-taxable. They're giving you back the money that you gave them. They're not giving you any extra. It's a return of capital. If the withdrawal exceeds the original investment, then the amount is treated as interest income. So hopefully you understand this concept. You should understand this concept. If I'm getting back my money, then I should not be taxed on that. If I'm getting back more than the money that I invested in that annuity, interest income will kick in. Let's start by looking at a simple example. Elias H50 buys an annuity from an insurance company for 45,000. So this is the investment. In exchange, Elias is to receive a lifetime payment of $480 starting at age 63. So notice, the insurance company is going to invest this money from age 50 to age 63. By age 63, they will start issue Elias a check for $480. Now, Elias investment cost is 45. This is the original balance. Elias would not have to recognize any income until he reaches 63 and start collecting the monthly payment. Now, how much of the monthly payment is taxable? We would look how to compute that. Given that this is a lifetime annuity, the amount of interest income to be reported, determine use in the IRS, life expectancy factor, and let's take a look at an example. Amy, an individual taxpayer, was 56 years when she purchased an annuity from an insurance company paying 120,000. That's Amy's investment. Amy is to receive lifetime monthly payment of $500. Great. Now, what do we do is this? If she's 57, would look at her life expectancy and she would expect it to live almost 30 years, 29.8. Now, this table is provided by the IRS. We don't have to worry about this. Now, what do we do next? Now, what we do is we take $500, her monthly payment times 29.8, times 12 months, and she would receive in total 178,800, assuming she expect to live all that time, 29.8. Now, the $500, how much of it is taxable? How much of it is not taxable? Well, let's take a look at the annual execution amount. The annual execution amount is computed by taking the 120 divided by 178,800. So, simply put, we're going to take the amount originally invested divided by the total expected based on the life expectancy, and that's 67.11%. So, 67.11% will be executed times, whatever we receive per year, we receive per year. If we take 12 times $500, we receive per year $6,000. So, of the amount of $6,000, $4,026.85 is executed. That's a return of the original capital. How did I find this percentage? It's what I invested divided by the total amount of money I expect to receive. How did I find out the amount of money I expect to receive? $500 times 29.8 times 12 months, 178,800, which is, so 67.11% of my payment is executed. What does that mean? It means the remainder, whatever the remainder of 100%, 100% minus 67, whether at approximately 33% is actually taxable. So, as a result, on an annual basis, Amy would receive a total amount of $6,000, of which $4,026, let's make it $4,027, represent a return of capital, the remainder, which is $6,000 minus $4,027, which is approximately $1,973, will be taxable. Now, let's assume that Amy lived longer than that 30 years. Well, once the investment is fully recoverable, because remember this is a lifetime investment, let's assume she lived more than 30 years, 29.8, that's fine. Then all the $500, 100% of it is taxable because Amy recovered the $120,000, now she's getting all interest income. So, this is an example of a lifetime annuity. Again, with Amy, here Amy is buying a plan, but she's going to be paid for a certain amount of time. So, when she was 57, she purchased an annuity for 65,000. Amy is to receive 500 over 12 years. Well, that's all what she wants. Why? We don't know. Maybe she has other income 12 years later that's coming to her. We don't care. The point is, she's going to receive a limited amount of money. Well, in this under those circumstances, we know that she's going to receive in total $72,000, which is $500 times 12 payments per year times 12 years, times 12 payments, which is $72,000. That's the total. The annual execution amount is computed by taking the investment divided by 12 years. So, we're going to take the 65,000 divided by 12 years and the executed amount per year is $5,416.67. So, every year, she would receive a total of $6,000 of which $5,416 is not taxable. The remainder is taxable. Whatever the difference between the 6,000 minus the 5,416.67, this amount is considered interest and it is taxable. Now, after 12 years, the insurance company would no longer pay Amy. Why? Because it was a fixed period annuity. It was not a lifetime annuity. Under a lifetime annuity, they pay you forever. There's something called the simplified method. I'm not sure if this is covered on the CPA exam or not. I just want to make sure it's covered for you. The simplified method is required by annuity distributor from qualified retirement plans. If you have a 401k and the 401k have an annuity, they use a slightly different formula. The execution amount is determined by dividing the initial investment by the number of anticipated monthly payment. So, the number of anticipated monthly payments is based on the age of the taxpayer and again, this will be provided to you. So, let's take a look at an example, explaining the simplified payment. Andy, an individual taxpayer who was 64 years old, invests $100,000 in a qualified retirement plan to receive a monthly annuity of $500. Well, determine the non-taxable amount. Well, Andy is 64, we go back to 64. 64 is between 61 and 65. We're looking at expecting monthly payment of 260. Simple, we're going to take based on the table presented above with the age of 64, Andy is expected to receive 260 payment. Therefore, we're going to take the 100,000, the investment, what Amy put in divided by 260 and that's going to be the non-taxable because this is my money, I'm getting my money back. Now, I'm receiving $500 as a payment. Well, $500 minus 384, let's make it 385 to keep the math simple, minus 385. What's left for me, I believe, if my math is right is 115, that's taxable. So, this is how I figure out my taxable amount using the simplified method. What about the 385? It's ROC, return of capital, an important concept, whether we are dealing with annuities, whether we are dealing with investments, whether we are dealing with pension plan, it's very important to understand the concept of return of capital, non-taxable. What should you do now? Go to FARHAP lectures, whether you are a CPA, enrolled agent, candidate, and look or an accounting student, and look at additional resources, multiple choice, true, false, exercises that's going to help you, either pass your certification or do better in your CPA exam or EA enrolled agent exam. Good luck, study hard, and of course, stay safe.