Question

Jay, a single taxpayer, retired from his job as a public school teacher in 2015. He is to receive a retirement annuity of $1,200 each month and his life expectancy is 180 months. He contributed $36,000 to the pension plan during his 35-year career; so his adjusted basis is $36,000. Jay collected 192 payments before he died. What is the correct method for reporting the pension income?

1) Since Jay is no longer working, none of the pension payments must be included in his gross income.
2) The first $36,000 received is a nontaxable recovery of capital, and all subsequent annuity payments are taxable.
3) The first $180,000 he receives is taxable and the last $36,000 is a nontaxable recovery of capital.
4) All of the last 12 payments he received ($14,400) are taxable.
5) None of these.

Answer 1

The first $36,000 of Jay's retirement annuity is not taxable as it is a recovery of his contribution to the pension plan. After that, all subsequent annuity payments are fully taxable. Since Jay received more than 180 payments, only the first 30 payments were non-taxable and the rest were subject to taxes.

Step-by-step explanation:

The correct method for reporting pension income in Jay’s situation is the partial taxability of annuity payments. According to the Internal Revenue Service (IRS) guidelines, the portion of each payment that represents a return of the after-tax amount that Jay contributed to the pension plan (his adjusted basis) is not taxable. Once the total of the nontaxable parts reaches the adjusted basis, any payments received thereafter are fully taxable.

The correct method is 2) The first $36,000 received is a nontaxable recovery of capital, and all subsequent annuity payments are taxable.

Jay's adjusted basis in the pension is $36,000, equivalent to the contributions he made during his career. His annuity payments are $1,200 monthly, and he was expected to live for another 180 months, creating an expected total return over the period. Jay received payments for 192 months, which exceeds his expected return period; therefore, most of his payments are subject to income tax. IRS guidelines allow for the recovery of the taxpayer's basis before any of the annuity is includable as income. Since Jay's pension payments are a fixed dollar amount, known as a 'defined benefit' plan, they will be taxed in a predictable manner.

Jay's pension will be partially taxable once the sum of his nontaxable pension received equals his $36,000 basis. Since he collected more than 180 payments, we can infer that he received his full basis back before he died. After the basis is recovered, the full amount of any further annuity payments becomes taxable income.