For NJ, I need to fill out the Three-Year Rule Method. I know the "Annuity Cost (basis)" is 'Total employee contributions.' What is the "Cost Recovered in Prior Years"?

[rjs · Accepted solution]

Under the three-year rule, the pension payments that you receive are assumed to be a return of your contributions until you have gotten back the full amount that you contributed. Since you already paid New Jersey tax on the amounts that you contributed, they are not taxable on your New Jersey tax return when you get them back as pension payments. "Cost Recovered in Prior Years" is the cumulative sum of the amount you received in prior years that was not taxable because you were recovering your contributions.

If this is the first year that you are receiving this pension, the cost recovered in prior years is zero. After the third year (i.e. starting in the fourth year), the cost recovered in prior years will be equal to the annuity cost (your total contributions), and the full amount of your pension payments will be taxable. That's the meaning of the three-year rule. You recover (get back) all your contributions within the first three years.

If you use TurboTax every year, and always transfer information from the previous year's tax return when you start your new tax return, TurboTax will keep track of the cumulative amount recovered, and the cost recovered in prior years will be filled in for you.

[ldarango]

Thank you!

[apergoli]

Can I recover my contributions earlier than 3 years or do I have to divide the total by 3 and only recover 1/3 per year? 

[rjs]

@apergoli 

You don't calculate an amount to recover each year. Starting with the first year that you receive the pension, the full amount that you receive each year is recovered that year, until you have recovered all of your contributions. Depending on the amounts, it might take 3 years or it might take less. If it takes more than 3 years you cannot use the three-year rule.

"Three years" means "36 months from the date you receive your first payment from the plan," so it could be spread over 4 calendar years.

[apergoli]

Thanks....  What if in my 1st year the pension pays out more than the total that I put in.    Can I deduct all of my contributions in the 1st year or do I need to spread it out? 

[rjs]

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@apergoli wrote:

Thanks....  What if in my 1st year the pension pays out more than the total that I put in.    Can I deduct all of my contributions in the 1st year or do I need to spread it out? 

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@apergoli 

In that situation you would deduct all of your contributions in that first year. You cannot spread it out. Then in all future years the full amount that you receive from the pension would be taxable.

[apergoli]

Thanks for your help...glad I asked....

[apergoli]

How is this handled on the federal 1040?  Is it the difference between block 1 (Gross distribution) and block 2a (Taxable amount)?  This must mean that the amount I put in gets deducted much more slowly....It seems like it will take 40 years...

[rjs]

@apergoli  The federal tax return does not use the three-year rule. If your 1099-R has a taxable amount in box 2a that is less than the gross distribution in box 1, you just use the taxable amount on the form. The payer is probably using the "simplified method" to calculate the taxable amount. And yes, it will take a lot more than 3 years to recover all of your contributions.

[apergoli]

Thanks...When I look this up in the 1040 instructions I see I can recoup this money a little sooner than 40 years if I adjust my taxable amount.  I save a bit this way but I'm afraid that any deviation from the 1099-R could trigger an audit.   Is this a valid concern?

[rjs]

@apergoli 

To recover your contributions sooner you would have to report a lower taxable amount than what's shown in box 2a of your 1099-R. What exactly do you see in the Form 1040 instructions that says you can do that?

The instructions do say that you can report a lower taxable amount if you are a retired public safety officer and part of your pension distribution is used to pay for health insurance. Do you meet these requirements? If so, you are not going to get in trouble with the IRS if you are legitimately entitled to use this option. Enter the 1099-R as it appears on the form. After you enter the 1099-R, when TurboTax asks whether the pension comes from employment as a public safety officer answer Yes, then answer the follow-up questions. TurboTax will calculate the taxable amount. On your Form 1040 the abbreviation PSO will be printed next to line 5b.

If you do not meet the requirements for the adjustment for insurance for a retired public safety officer, I wouldn't mess with the taxable amount. If you report a lower taxable amount than what's in box 2a of your 1099-R the IRS wouldn't even have to do an audit. They will just send you a notice saying that the amount you reported is wrong and you have to pay additional tax plus penalties and interest.

[apergoli]

Thanks... I don't qualify as a public safety officer although I am pretty careful.    The instructions regarding pensions simplified method worksheet points to a table 2.  Our combined age is 112 which indicates I can recover my contributions in 360 months or 30 years instead of the 40 years calculated on my 1099-R.  Did I misinterpret something?

[DawnC]

Under the Simplified Method, you figure the tax-free part of each annuity payment by dividing your cost by the total number of anticipated monthly payments. For an annuity that is payable for the lives of the annuitants, this number is based on the annuitants' ages on the annuity starting date and is determined from a table. For any other annuity, this number is the number of monthly annuity payments under the contract.

If your annuity is payable for your life alone, use Table 1 at the bottom of the worksheet to determine the total number of expected monthly payments.

If your annuity is payable for the lives of more than one annuitant, use Table 2 at the bottom of the worksheet to determine the total number of expected monthly payments.

Under the General Rule, you determine the tax-free part of each annuity payment based on the ratio of the cost of the contract to the total expected return. Expected return is the total amount you and other eligible annuitants can expect to receive under the contract. To figure it, you must use life expectancy (actuarial) tables prescribed by the IRS.

Pub 575 Simplified Method      @apergoli 

[Stefanie88P]

If you live in PA and collecting NJ pension, does 3 yr rule still apply? State taxes paid to PA or NJ, after original investment is paid out?