How Pensions & Annuities Are Taxed (Simplified Method)

A pension check or annuity deposit lands in your account looking like a single number. The IRS does not see it that way. Depending on how the plan was funded, that payment is either fully taxable, fully tax-free, or — most commonly — split between the two, month after month, for years. Getting the split right is the entire job of the Simplified Method.

The One Question That Decides Everything

Ask: did you (or your employer, on your behalf) ever put after-tax dollars into this pension or annuity?

• No after-tax contributions — the plan was funded entirely with pre-tax salary deferrals, pre-tax employer contributions, or a rollover from a pre-tax account (Traditional 401(k), Traditional IRA). This is the overwhelming majority of employer pensions and IRA-funded annuities. Every dollar of every payment is taxable as ordinary income in the year received, because you never paid tax on any of the money going in.
• Some after-tax contributions — you made after-tax employee contributions to a pension plan, purchased a commercial annuity with after-tax savings, or rolled after-tax basis into an IRA. That after-tax amount is your cost basis (also called “investment in the contract”). You get that basis back tax-free, spread evenly across your expected payments. Everything above it is taxable.
• All after-tax dollars, no earnings yet realized — rare, but if your cost basis equals or exceeds what you’ve been paid so far, payments are tax-free until the basis is used up.

There is no election involved in which of these three buckets you’re in — it’s determined entirely by how the contract was funded. The plan administrator reports your gross distribution and, usually, the taxable amount on Form 1099-R; when box 2a is blank or marked “taxable amount not determined,” you (or your software) must run the Simplified Method yourself.

Simplified Method vs. the General Rule

IRS Publication 575 provides two methods for figuring the taxable and tax-free parts of a partially-taxable pension or annuity:

For qualified-plan annuities that started on or before July 1, 1986, and before November 19, 1996, filers had a choice between the two methods and generally must keep using whichever one they originally elected. Today, almost every newly-starting qualified pension or annuity uses the Simplified Method, so that’s what the rest of this article — and the Pension & Annuity Tax Calculator — walks through.

The Expected-Number-of-Payments Tables

The core of the Simplified Method is a fixed table that converts your age (or, for a joint-and-survivor annuity, the combined ages of both annuitants) at the annuity starting date into an “expected number of payments.” These figures come straight from the Simplified Method Worksheet in IRS Publication 575 and have not changed since they were set by the Small Business Job Protection Act of 1996 — they are not inflation-indexed and do not vary by tax year.

Table 1 — Single-life annuity (annuity starting date after November 18, 1996):

Table 2 — Multiple-lives annuity, by combined ages of both annuitants at the annuity starting date:

These tables assume monthly payments. If your annuity pays quarterly, semiannually, or annually, Pub 575 provides a multiplier to convert the monthly expected-payments figure — the tables above are the monthly baseline used by the calculator.

The Formula

Once you know your expected number of payments, the Simplified Method Worksheet runs in a fixed sequence (worksheet line numbers in parentheses):

1. Monthly tax-free amount (line 4) = cost basis (line 2) ÷ expected number of payments (line 3).
2. This year’s tax-free amount before any cap (line 5) = monthly tax-free amount × number of monthly payments received this year.
3. Cost already recovered in prior years (line 6) = the running total of tax-free amounts you’ve claimed in every year since the annuity started.
4. Unrecovered cost entering this year (line 7) = total cost basis (line 2) − prior-year recovery (line 6).
5. This year’s actual tax-free amount (line 8) = the smaller of line 5 or line 7 — this is what stops the exclusion once your basis runs out.
6. Taxable amount for the year (line 9) = total payments received (line 1) − line 8, never below zero.

The tax-free dollar amount is constant every month for as long as basis remains — it doesn’t fluctuate with cost-of-living adjustments to your payment, and it doesn’t reset annually. It’s the same flat number, multiplied by the number of payments, until the cumulative total hits your original cost basis. After that, line 7 drops to zero and every subsequent payment is 100% taxable.

Worked Example A — Single-Life Annuity, Age 65

Maria retires and begins a single-life pension annuity at age 65. She made after-tax employee contributions totaling $30,000 over her career (her cost basis). Her monthly payment is $1,800.

• Age at annuity starting date: 65 → falls in the 61–65 bracket → 260 expected payments (Table 1).
• Monthly tax-free amount = $30,000 ÷ 260 = $115.38.
• Monthly taxable amount = $1,800 − $115.38 = $1,684.62.
• Annual total payments (12 months) = $21,600.
• Annual tax-free amount = $115.38 × 12 = $1,384.56.
• Annual taxable pension income = $21,600 − $1,384.56 = $20,215.44.

Maria will keep excluding $115.38 of every monthly check until her cumulative tax-free recovery reaches her $30,000 basis — that happens after exactly 260 payments (the expected-payments figure is, by design, the number of payments over which the basis is fully amortized). At $1,800/month that’s about 21 years and 8 months into retirement. From that point forward, her entire monthly payment is taxable, even though nothing about the payment itself changed.

Worked Example B — Joint-and-Survivor Annuity

David, 65, and his wife Anne, 62, start a joint-and-survivor annuity that will continue paying Anne for life if David dies first. Their combined cost basis (David’s after-tax contributions) is $45,000, and the monthly payment is $2,200.

• Combined ages at annuity starting date: 65 + 62 = 127 → falls in the 121–130 bracket → 310 expected payments (Table 2).
• Monthly tax-free amount = $45,000 ÷ 310 = $145.16.
• Monthly taxable amount = $2,200 − $145.16 = $2,054.84.
• Annual total payments = $26,400.
• Annual tax-free amount = $145.16 × 12 = $1,741.92.
• Annual taxable pension income = $26,400 − $1,741.92 = $24,658.08.

Because it’s a joint-and-survivor contract, Anne continues using the same $145.16 monthly tax-free amount and the same 310-payment expected total if she survives David — the expected-payments figure was set once, at the annuity’s start, using both of their ages, and does not get recalculated when the first annuitant dies.

After Prior Years: How the Recovery Cap Works

The worksheet isn’t just a one-time calculation — it tracks cumulative recovery every year. Suppose Maria (Example A) is now in her fourth year of payments and has already received 36 monthly payments:

• Prior-year recovery (line 6) = $115.38 × 36 = $4,153.68.
• Unrecovered cost entering this year (line 7) = $30,000 − $4,153.68 = $25,846.32.
• This year’s tax-free amount before cap (line 5) = $115.38 × 12 = $1,384.56.
• Since line 5 ($1,384.56) is smaller than line 7 ($25,846.32), the full $1,384.56 is tax-free this year (line 8) — no cap applies yet.

The cap only bites in the final year of recovery, when the remaining unrecovered basis is smaller than a full year’s worth of tax-free payments — at that point line 8 is limited to whatever basis is left, and the year after that, line 7 is zero and 100% of every payment is taxable.

Once Basis Is Fully Recovered

There is no ongoing tax break once your after-tax cost basis has been fully recovered. From that point on, 100% of every pension or annuity payment is ordinary taxable income, reported the same as any other pension distribution, for as long as you (or a surviving joint annuitant) keep receiving payments. This is true even though the underlying annuity contract may keep paying for decades beyond the original “expected number of payments” — the expected-payments table is an actuarial average, not a guarantee, so plenty of annuitants outlive it and receive years of fully-taxable payments after their cost basis is exhausted.

If, instead, the annuitant dies before recovering the full cost basis, the unrecovered balance (worksheet line 11 as of the date of death) is allowed as a miscellaneous itemized deduction on the decedent’s final income tax return.

Early-Distribution and RMD Interactions

Pension and annuity income sits inside a broader web of retirement-account rules that the Simplified Method doesn’t touch directly, but interacts with:

• Early-distribution additional tax. If you start receiving payments from a retirement plan or annuity before age 59½, the taxable portion (not the tax-free return-of-basis portion) is generally subject to an extra 10% tax on top of ordinary income tax, unless an exception applies — disability, certain medical expenses, a qualifying series of substantially equal periodic payments under IRC §72(t), and others. The 10% additional tax is assessed on the same taxable amount your Simplified Method worksheet produces; the tax-free basis-recovery portion is never subject to it.
• Required Minimum Distributions. A defined-benefit pension or a commercial annuity that is already paying out in substantially equal periodic payments over your life (or life expectancy) generally satisfies its own RMD requirement by virtue of the payout structure itself. But if the annuity sits inside an IRA or employer plan that hasn’t yet been fully annuitized, the account can still be subject to separate RMD rules until distributions begin. See the calculator’s companion RMD guide (linked below) for the life-expectancy tables that govern IRA and 401(k) RMDs.
• Taxable pension income counts toward provisional income. The taxable portion computed here is ordinary income and is included when figuring whether your Social Security benefits are taxable (see the Social Security taxability guide below) — a larger taxable pension can push more of your Social Security into the taxable column.

State Tax Treatment Varies Independently of Federal Rules

The Simplified Method only determines your federal taxable amount. States are not required to follow it, and many diverge:

• No state income tax at all (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, Wyoming): the entire federal question is moot at the state level.
• Full or partial pension exemptions: a number of states exempt some or all pension and retirement-annuity income for residents above a certain age, or exempt government/military pensions specifically while taxing private pensions in full. These carve-outs are set entirely by state statute and are unrelated to the federal cost-basis mechanics above.
• Full conformity: many states simply start from federal taxable income (including your Simplified Method result) and tax it at ordinary state rates with no separate pension adjustment.

Because state rules are set independently, confirm your specific state’s treatment of pension and annuity income before assuming your federal Simplified Method result carries through unchanged.

Common Mistakes to Avoid

• Recomputing the tax-free amount every year. The monthly tax-free dollar figure is fixed once, at the annuity’s starting date, using your age at that time. It is not recalculated annually even if your payment amount changes.
• Forgetting to track prior-year recovery. If your 1099-R doesn’t show a taxable amount and you’re doing the worksheet yourself, you need an accurate count of how many payments you’ve already received (and how much basis you’ve already recovered) — losing this record is the single most common Simplified Method error, especially years into an annuity.
• Applying it to a Roth account. There’s no cost-basis split to compute on a qualified Roth distribution — see the FAQ below.
• Missing the switch to fully taxable. Once cumulative recovery hits your cost basis, filers sometimes keep excluding the old monthly amount out of habit. Re-check line 7 of the worksheet each year the basis is close to exhausted.

Related Reading

• Is Social Security taxable in 2026? — how taxable pension income affects the provisional-income test
• RMD table 2026: IRS Uniform Lifetime + Joint Life tables — the separate life-expectancy divisors that govern IRA/401(k) required minimum distributions
• Roth vs. Traditional IRA: which is better? — how the pre-tax vs. after-tax funding decision shapes taxation decades later, the same principle behind cost basis here

FAQs

Do I need to run the Simplified Method myself, or does my plan do it?

Most pension administrators and insurance companies do the calculation for you and report the taxable amount in Box 2a of Form 1099-R. You need to run the worksheet yourself when Box 2a is blank or marked “taxable amount not determined” — which is common for the first year or two of a new annuity, or when a plan doesn’t track your cost basis. Once you or your software has completed it once, the same monthly tax-free amount typically carries forward unchanged for the life of the payments.

What if I have no after-tax contributions at all?

Then there’s no cost basis to recover, and the Simplified Method doesn’t apply because there’s nothing to split — the entire payment is taxable from day one. This describes most Traditional 401(k) pensions, Traditional IRA-funded annuities, and employer pensions funded solely by the employer with no employee after-tax contributions.

Can the taxable and tax-free split change from year to year?

The monthly tax-free dollar amount is fixed for the life of the annuity once it’s calculated — it doesn’t adjust for inflation or cost-of-living increases in your payment. Because your payment itself may grow (a COLA-adjusted pension, for example) while the tax-free amount stays flat, the percentage of each payment that’s taxable typically rises slightly over time, until the basis is exhausted and the split becomes 100% taxable.

Is a Roth 401(k) or Roth IRA annuity taxed the same way?

No. Qualified distributions from a Roth account are tax-free entirely, so the Simplified Method doesn’t apply — there’s no partially-taxable split to calculate. The Simplified Method is specifically for annuities and pensions that mix pre-tax and after-tax money in the same contract.

Does the Simplified Method apply to disability pensions or annuities purchased before November 19, 1996?

Not automatically. Disability annuities and pre-November-1996 annuity starting dates carry their own rules under Pub 575 — in some cases the taxpayer who originally elected the General Rule must continue using it, and disability retirement income before minimum retirement age may be treated as wages rather than a pension. These situations fall outside the scope of this calculator; consult a tax advisor or Pub 575 directly.