Probably the most common reason taxpayers receive IRS notices is omission of income from their tax returns. The IRS learns about omitted income by receiving 1099 reports from the entities that made payments to taxpayers. In many cases, a taxpayer is simply uncertain of the tax treatment for some types of 1099s. This is why individuals who receive 1099s should rely upon tax preparation professionals such as enrolled agents.

Sometimes not all of the amount reported on a 1099 is taxable. This can confuse even highly intelligent individuals. One such case involves a 1099-R for annuity payments received. Fortunately, the tax calculation and information required for annuities is covered in enrolled agent CPE.

Surprisingly, some annuity recipients are unaware that the payments received incur any income tax. They are sometimes mistakenly told that there is no tax impact until their entire investment in the annuity is recovered. Not so surprisingly, replying upon uninformed individuals for tax advice also results in such misinformation as the notion that income averaging is applicable to determining the tax on annuity payments. As every pro completing enrolled agent study knows, neither of these instructions is correct.

Every annuity payment is allocated between an income component and a portion representing recovery of the investment contributions. The nontaxable part is determined by applying the ratio of annuity contributions to the total expected payments under the contract. That is the percentage of total payments represented by the investment amount.

This is the formula used since 1986. It replaced the old cost recovery method and applies to all annuities that started after July 2, 1986. Prior to that, a taxpayer could exclude all annuity payments from income until full recovery of the invested amount as long as payout of the entire investment was expected within three years.

There may be some taxpayers receiving annuities that started payments prior to 1986, but not many. When an IRS enrolled agent works for a taxpayer who recently started receiving annuity payments, a correct taxable component is determined.

Five-year forward averaging is available for an annuity with a lump-sum distribution. That is a trick covered in an enrolled agent training course. But it is not often applicable because most annuities are paid out in monthly payments. It does not apply to taxpayers receiving periodic annuity payments. The best course of action for an annuity recipient is to avoid confusion from amateur tax advisors and rely upon the expertise of an enrolled agent.