When you receive pension or annuity payments, part of each payment may be tax-free because it represents a return of the after-tax contributions you made to the plan. This is often referred to as your cost basis or investment in the contract.
If you don't recover your entire investment through tax-free annuity payments before the annuity ends due to your death, the remaining unrecovered amount may qualify as an itemized deduction on the decedent's final tax return.
Why Does the Annuity Starting Date Matter?
Your annuity starting date determines how the tax-free portion of your annuity payments is calculated.
Once established, the annuity starting date doesn't change, and it continues to govern the exclusion amount for the life of the annuity.
The tax treatment differs depending on when the annuity began.
Annuities That Started Before 1987
If your annuity starting date was before 1987, the exclusion generally isn't limited to the cost of the annuity.
You can typically continue excluding the same tax-free portion of each payment for as long as you receive annuity payments, even after you've recovered your original investment.
Annuities That Started After 1986
If your annuity starting date was after 1986, the total tax-free amounts excluded by the employee and any survivor annuitant generally can't exceed the after-tax cost basis in the annuity.
Once the entire investment has been recovered, future payments are generally fully taxable.
If the annuitant dies before recovering the full cost basis, the remaining unrecovered investment may qualify for a deduction on the final income tax return.
When Can an Unrecovered Investment Be Deducted?
An unrecovered investment deduction may be available when:
- The annuity began after 1986.
- The annuitant dies before fully recovering their after-tax investment.
- A portion of the original cost basis remains unrecovered at the date of death.
The deductible amount is generally the remaining unrecovered investment in the pension or annuity.
How Do I Enter an Unrecovered Investment in a Pension or Annuity?
To enter this deduction in our software, follow these steps:
- Federal Section
- Deductions – Select My Forms
- Itemized Deductions
- Other Itemized Deductions
- Unrecovered Investment in Pension
Enter the unrecovered amount shown in your records or tax documents.
What Records Should I Keep?
To support the deduction, keep documentation showing:
- The original after-tax investment in the pension or annuity
- The tax-free amounts recovered over time
- The remaining unrecovered balance
- Any Forms 1099-R or statements from the plan administrator
These records can help verify the deduction if additional information is ever requested.