- Taxes on TCRS Benefits
I. Federal Income Taxes
The Tennessee Consolidated Retirement System (TCRS) is a qualified pension plan under Section 401(a) of the Internal Revenue Code and payments received from TCRS are taxed according to the rules that apply to qualified pension plans. As explained below, the rules vary depending on the type of payment you receive. Keep in mind that tax rules are subject to revision by Congress, so you should obtain current information at the time you become eligible for payment. A Special Tax Notice Regarding Plan Payments written by the IRS provides detailed information on the tax treatment of distributions.
A. Refunds/Lump Sum Distributions
If you elect to take a refund from the plan in lieu of monthly benefits, IRS calls that refund a lump sum distribution. The full amount of the distribution will be taxable unless you have made after-tax contributions to TCRS. If you have made after-tax contributions to TCRS, the portion of the distribution which is a return of those contributions will be nontaxable. Payment for any nontaxable portion of your refund will automatically be issued to you; however, you will have a choice regarding payment of the taxable portion of your refund. You may elect to have the taxable portion of your refund (1) transferred to an Individual Retirement Arrangement or another retirement plan, or (2) paid to you. The choice you make will affect the tax you owe.
1. Direct Transfer or Rollover
The TCRS Refund Application allows you to elect to have the taxable portion of your refund transferred directly to a regular Individual Retirement Account (IRA) or to another qualified retirement plan for which you are eligible. If you elect a direct transfer, TCRS will issue payment for the taxable portion of your refund directly to the new plan and that amount will not be included in your gross income until you take the money out of the new plan. Therefore, you will not be subject to ordinary income tax, early distribution tax, or tax withholding. (As an alternative to a direct transfer, IRS rules allow you to make a rollover yourself within 60 days of receiving a lump sum distribution check; however, this method is generally not desirable because withholding taxes must be applied first, leaving only 80 percent of the taxable amount available for rollover.) For more information on rollovers, see IRS publication 575, Pension and Annuity Income and IRS Publication 590, Individual Retirement Arrangements (IRAs).
2. Refund Paid to You
If you receive a refund, the taxable portion must be reported as income on your federal tax return for that year. As required by federal law, TCRS will withhold 20 percent of any taxable amount paid to you and send it directly to the IRS to be applied toward the federal income taxes you will owe for the year. There are two types of federal income taxes which may ultimately apply to the taxable amount of a refund which is paid to you: ordinary income tax and an early distribution penalty tax.
Ordinary Income Tax
The taxable portion of a lump sum distribution which is paid to you is includible in gross income and taxed as ordinary income in the year it is received unless one of the following special tax treatments is used:
- Forward Income Averaging
If you take a lump sum distribution, forward income averaging tax treatment lets you figure your income tax as if you received the money over ten years instead of one year. It is also figured separately from tax on any other income, so it can sometimes result in considerable tax savings. If you were born on or before December 31, 1935, you may be eligible to use ten year averaging. You must have belonged to the plan for five years or longer to qualify for forward averaging. Refer to IRS publication 575 Pension and Annuity Income and IRS Form 4972 for information.
- Capital Gains Tax
If you were born on or before December 31, 1935 and if your refund includes employee contributions made before January 1, 1974, you may elect to use long-term capital gain tax treatment on a percentage of the taxable amount of the refund. To qualify, you must have participated in the plan for five years or longer. The percentage of the refund which is eligible for this treatment is generally determined by dividing the months of participation before 1974 by the total months of participation. If you qualify, you may write to TCRS for information regarding the amount of your refund which may be given this treatment. For more information, see IRS publication 575, Pension and Annuity Income and IRS form 4972.
Early Distribution Tax Penalty
Any taxable amount refunded to you is also subject to a separate 10 percent early distribution tax unless one of the following exemptions applies:
- Age 55: If you were 55 or older when you separated from TCRS-covered service, your refund is exempt from the early distribution penalty tax.
- Age 59½: If you are 59½ or older when you receive the refund, it is exempt.
- Disability: If you are receiving the refund as a result of your disability and can provide proof of this to the IRS, it will be exempt from the early distribution penalty tax.
- Medical Expenses: If you have certain medical expenses which exceed 7½ percent of your gross income in the year you receive the refund, the refund may be exempt from this tax.
- Death: If a beneficiary receives a refund due to a member's death, it is exempt from this penalty tax.
Determination and payment of the early distribution tax penalty is the responsibility of the individual. Refer to IRS Form 5329 for information.
Generally, the taxable amount of a refund that is paid to you is subject to 20 percent withholding tax. (If you are over age 70½, a lower rate may apply.) TCRS will send the amount withheld to the IRS to be applied toward any ordinary income tax or early distribution penalty tax you owe. The amount withheld may be more or less than you will actually owe as a result of the distribution. At the time the refund check is issued, TCRS will send you a substitute 1099-R form showing the amounts of taxable income and withholding taxes reported to IRS. This form should be kept for tax purposes. If you decide to deposit the taxable amount of your refund to an IRA yourself within the 60 day period allowed by IRS, the amount withheld cannot be rolled over and taxes on that amount cannot be deferred. Refer to the Special Tax Notice Regarding Plan Payments for full information on withholding on refunds.
B. Monthly Retirement Benefits
Payments members receive from TCRS must be reported as pension benefit income in the year(s) received. Benefits received from TCRS will either be fully taxable or partially taxable.
1. Fully Taxable Benefits
Monthly benefits received by noncontributory members who have never made contributions to the retirement system will be fully taxable.
Monthly benefits received by members whose retirement contributions have always been tax-deferred under Section 414(h) of the Internal Revenue Code will also be fully taxable. (All teachers and many local government employees have made tax-deferred 414(h) contributions since January 1, 1987.)
2. Partially Taxable Benefits
Monthly benefits received by members who have previously made after-tax contributions* to the retirement system will be partially taxable. (See definition in footnote.) Since the member has already paid income taxes on those contributions, the amount of those contributions will be excluded from taxable income when benefits are paid. The formula for this calculation bases the nontaxable portion of the benefit on the ratio of the member's contributions to the total benefits expected to be paid. In most cases, TCRS will make this calculation and will report the taxable amount on the 1099-R. If you want to estimate what the taxable and nontaxable portion of your monthly benefit will be, you can use the following IRS table. Divide the amount of your after-tax contributions by the number of payments anticipated under the table to determine the amount excluded from taxation each month.
Age at Retirement
Number of Payments
55 or under
71 or over
If the member (and the beneficiary if an option is selected) die before the full number of excludable payments shown above have been received, the unrecovered cost (previously taxed contributions) may be used as a miscellaneous itemized deduction on the final return of the member.
3. Disability Benefits
Monthly disability benefits from TCRS are fully taxable until the benefit is converted to a regular retirement benefit at age 60 or death. After that point, a taxable and nontaxable portion of the monthly benefit will be calculated by TCRS if the member made any after-tax contributions. Members who retired on disability may be eligible to claim the Credit for Elderly or the Disabled using Schedule R. For more information on this tax credit, refer to IRS Publication 17, Your Federal Income Tax and IRS Publication 524, Credit for the Elderly or the Disabled.
4. Withholding on Monthly Benefits
Withholding taxes will normally be applied to payments you receive from TCRS. When you apply for benefits, you will be asked to complete a Form W-4P Withholding Certificate. Withholding on monthly benefits will be based on your marital status and the number of withholding allowances claimed. You may file a new Withholding Certificate at any time. If you do not file a Withholding Certificate, withholding taxes will normally be calculated as if you were married with three exemptions. When you are arranging withholding, keep in mind that individuals who do not pay at least 90 percent of their tax liability during the year may be subject to tax penalties. TCRS will provide each recipient of monthly benefits with an annual 1099-R form which will show the yearly income from TCRS and the total amount withheld. In most cases, the 1099-R form will also show the amount of the income which is taxable.
C. Payments to Beneficiaries
Special tax rules may apply to beneficiaries, depending on the method of payment elected and the circumstances.
The taxable portion of a lump sum distribution paid to a beneficiary will be reported in the beneficiary's name. Refunds paid to beneficiaries are not subject to an early distribution tax penalty, regardless of the age of the member or the beneficiary. Refunds paid to beneficiaries are not eligible for rollover unless the beneficiary is the member's spouse. A spouse who elects to take a refund from the plan in lieu of monthly benefits may elect to have those monies transferred directly to a regular Individual Retirement Arrangement (IRA), but not to a qualified retirement plan.
2. Monthly Benefits
Monthly benefits received by a member's beneficiary will generally be taxed in the same manner as benefits received by a member. If the beneficiary of a member who made after-tax contributions to TCRS is entitled to a monthly benefit, the calculation of the taxable and nontaxable portion of the member's benefit will continue to apply to benefits received by the surviving beneficiary until the number of payments allotted have been excluded. Monthly benefits paid to the beneficiary will be reported on a 1099-R form in the beneficiary's name.
3. Payments to Beneficiaries of Law Enforcement Officers Killed in the Line of Duty
Amounts paid to survivors of public safety officers killed in the line of duty are excludable from taxable income.
D. Penalty for Failure to Begin Distributions
Under federal law, you must normally take a full refund or begin drawing your lifetime monthly annuity benefits by April 1 of the year following the year in which you reach age 70½ or retire, whichever is later. If you do not meet the distribution provisions required by the IRS, federal law imposes a penalty tax equal to 50 percent of the amount you should have withdrawn that year but didn't. For this reason, it is very important for anyone who leaves covered employment and who is entitled to any future payment(s) from TCRS to keep the retirement system informed of any changes in address. Refer to IRS Publication 575, Pension and Annuity Income for more information on IRS withdrawal rules.
II. State Income Taxes
The State of Tennessee does not apply a state income tax to TCRS benefits (or to any other pension benefits) received by state residents.
III. Federal and Tennessee Estate Taxes
Generally, retirement benefits payable to a survivor from the TCRS are included in the taxable estate of the member. Estate tax will not normally be due on the payment of retirement benefits to a member's spouse since the net value of property passing to a surviving spouse usually does so free of federal and Tennessee estate taxes. Different federal and state exemption limits currently apply to property passing to someone other than the spouse.
Tennessee Inheritance Tax: In 2005, property (including TCRS benefits) having a value of less than $950,000 can pass to someone other than the member's spouse free of Tennessee inheritance tax. The exempted amount becomes $1,000,000 in 2006 and after.
Federal Estate Tax: In 2005, property (including TCRS benefits) having a value of less than $1,500,000 can pass to someone other than the member's spouse free of federal estate tax. The exempted amount becomes $2,000,000 in 2006 and $3,500,000 in 2009.
IV. For More Information
Questions concerning federal taxes on payments from the retirement system should be directed to the Internal Revenue Service, a professional tax advisor, or an attorney. IRS publications and forms are available free of charge. To obtain the ones you need, call 1-800-829-3676, download them from the IRS site, visit a local IRS office, or write to the IRS Distribution Center, P.O. Box 9903, Bloomington, IL 61799. Questions concerning Tennessee estate taxes should be directed to the Tennessee Department of Revenue, a professional tax advisor, or an attorney licensed to practice in Tennessee.
- After-Tax Contributions are contributions the member made after federal income tax had been applied to the full amount of his or her salary. Since the member has already paid income taxes on those amounts once, they won't be taxed again when they are paid out in the form of a refund or monthly benefits. If you have ever made after-tax contributions to TCRS, the amount of those contributions will be shown on your annual TCRS statement.
- Group 1 state employees made after-tax contributions to TCRS until 1981 and have not made contributions to TCRS since then.
- Other state employees (including members of Groups 2, 3 and 4) made after-tax contributions until 1987. Contributions made since January 1, 1987 have been tax deferred under Section 414(h) of the Internal Revenue Code.
- Teachers made after-tax contributions to TCRS until 1987. Contributions made since January 1, 1987 have been tax deferred under Section 414(h) of the Internal Revenue Code.
- Political subdivision employees may or may not make after-tax contributions, as determined by the political subdivision.
Revised May 2005