With tax season coming up quickly, it is never too early for tax preparers to start refamiliarizing themselves with many common forms. In this podcast, we take a detailed look at Form 1099-R, which pertains to distributions from pensions, annuities, retirement plans, and more. Walking us through the specifics are Gail Hauseman, owner of Berkshire CPAs LLC, and Rodger Krause, owner of Rodger Krause CPA, both of whom are based in Wyomissing, Pa. They cover differences between state and federal versions of the form, what constitutes an eligible retirement plan, and more.

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By: Bill Hayes, Pennsylvania CPA Journal Managing Editor

Podcast Transcript

With tax season coming up quickly on the horizon, today we will discuss Form 1099-R, including the information it is meant to collect, first steps taxpayers should take if they should receive a letter proposing an increase in their income tax, and rules specific to Pennsylvania 1099-R forms that are different from the federal version. For this conversation, we are joined by Gail Hauseman, owner of Berkshire CPAs LLC, and Rodger Krause, owner of Rodger Krause, CPA, both in Wyomissing.

Can you let us know what sort of information a 1099-R is meant to collect? What does it show or address?

[Hauseman] A 1099-R is an informational form that a taxpayer's going to get from a retirement plan administrator. It's to indicate retirement benefits from pensions, IRAs, annuities, insurance contracts, etc. If someone gets more than $10 in a calendar year from a retirement plan, they'll get this form 1099-R. It's going to show them their distribution, how much of it is taxable. Sometimes the administrator doesn't know how much is taxable and they will indicate that on the form. They'll indicate how much federal withholding you have, state withholding. They'll also give you a code number that will help you report the distribution on your federal and state tax return.

If a taxpayer receives a letter from the Pennsylvania Department of Revenue, and it proposes an increase in their income tax, what's the first thing they should do?

[Krause] Well, hopefully the taxpayer briefly looked over the letter. But the really important thing that they should do is forward it to their CPA.

We might have to contact the Department of Revenue. We might be in disagreement with what the Department of Revenue is proposing in their letter. Often times, Revenue proposes a change in taxable income because of information that's not completely available to them, or it could be some other reason why they're proposing the change. We have to write a letter explaining things as they really were.

For instance, I had a client who received a letter proposing an increase to their tax because of an auto fringe benefit. I know this isn't a retirement issue. But my point is, the auto fringe benefit wasn't properly reported on the form, which in this case was a W2. Once we contacted the Pennsylvania Department of Revenue, we got that cleared up.

Also, as PICPA members, we know some Department of Revenue employees who are also PICPA members and we can reach out to them to assist us in resolving some of the letters with disagreements that we get.

Are there rules specific to 1099-R forms in Pennsylvania that are perhaps different from those of the federal version?

[Hauseman] Pennsylvania is a retirement-friendly state. For some background, Pennsylvania's not going to tax us on our qualified retirement income, it doesn't tax us on Social Security income. But the big indicator there is qualified. What is qualified retirement income?

So the big difference between fed and Pa. is when you and I put away contributions toward retirement, we get a federal deduction from our wages, or from our federal income. On the state side, we don't get that deduction as we put away money into retirement. Then on the back end, on the federal side, we've never paid tax on that money. That's why, when you take it out of a retirement plan, you do pay tax at that time, on the federal return. But on the state return, if you're taking money out after you're 59 and a half, and from your qualified plan, you don't pay tax on that.

We're lucky to live in a retirement-friendly state.

As was referred to right there, Pennsylvania doesn't tax income reported on 1099-R from eligible retirement plan. What exactly constitutes an eligible retirement plan?

[Krause] For Pennsylvania, there's a lengthy definition of what is an eligible retirement plan. It starts off by mentioning for Pennsylvania tax purposes that there's three plans that are considered eligible retirement plans. They're the state employees retirement system, the Pennsylvania municipal employees retirement system, and United States Civil Service Commission retirement disability plan. None of these retirement distributions are ever taxable for Pennsylvania purposes. In addition, an eligible Pennsylvania retirement plan has to meet four conditions.

The plan has to be written and is communicated to the employee. The plan establishes eligibility requirements for separation of service, old age, infirmity, or long-term service. Third, the plan provides recurring payments after separation of service until death. Fourth, the plan does not permit distributions until termination of employment except for disability or return of employee previously taxed contributions.

I know that's a lengthy definition, and it can be difficult to digest at times, but that is how the Department of Revenue sets forth retirement plan eligibility.

To get a little specific into the 1099-R, what are the federal codes in box seven of the 1099-R? How do they help indicate taxability of a distribution?

[Hauseman] The codes on the 1099-R are quite specific. There's nine different numeric codes and 20 different alpha codes that can go on this form, so there's a lot of different information to digest. I'll just go over the most common ones that we CPAs typically see.

Code seven means this is a normal distribution from an eligible retirement plan, you're over age 59 and a half. So, a code seven is taxed on your federal return, but Pennsylvania does not tax the code seven normal distribution because that tells them you're over 59 and a half. It would be from an eligible plan. Unless it's from an employee stock ownership plan, which most ESOPs are not Pa. eligible retirement plans. In that case, the Department may want to review your plan to make sure that it is or is not eligible.

Another common code is the code G, that's a trustee to trustee rollover of retirement money. Usually, you do that when you go from a 401K plan to an IRA. You never take possession of the money, it just goes right from one house to another, and the code G just indicates a rollover. Not taxable, federal or state.

Now a code one, it means that you took an early distribution from your retirement plan, and there was no known exception. When we take early distributions, and that would be before you're 59 and a half, there's a few instances where that might be warranted, where there's an exception. That would be, for instance, if you're taking IRA money to buy your first home. You can use $10,000 for that purpose. Or, if you have a hardship, or if you need money to pay for college. There's also a new exception with the SECURE Act, $5,000 for adoption expenses. There is a nice list of exceptions, where you would not have to pay a 10% penalty on your federal tax return. You'll still have to pay federal tax on the distribution. But, if you don't have an exception, it's an extra 10% penalty federal.

Now for Pennsylvania, what they'll do with an early distribution is they want you to take that gross distribution and then subtract out your contributions that you've made to the plan. Because remember, Pennsylvania didn't let us take deductions for all those contributions. So to not tax us twice, they're going to let you deduct your contributions from an early distribution. You'll only pay tax on the amount that you didn't contribute. At least they're giving us that assistance with that early distribution.

There is a code two where the 1099-R administrator knows that you had an exception. So, a code two means an early distribution, where an exception applies. They know there's some sort of exception, so you shouldn't have to pay that 10% early penalty. The most common way I see a code two is when you do a ROTH conversion from a regular IRA to a ROTH, that's a code two event. For that particular code two, Pennsylvania does not tax ROTH conversions. But, for a lot of other code twos, most other code twos, it's the same rules. You're going to have to take that gross distribution and you're going to have to compare that to your contributions. Any extra distribution you will pay tax on that in Pennsylvania. That's the biggest difference between fed and state, with those early distributions.

Another common code I see is a code F, it's from a charitable gift annuity. Recipients of income from charitable gift annuities with code F report that on their Pennsylvania tax return as interest income. Those are some of the most common codes we see. But, again, there's a laundry list of others.

Are there any other unusual situations you'd like to share that you've seen, regarding Pennsylvania taxability of retirement distributions?

[Krause] If there is a code D, it often times follows the number seven, seven-D. In box seven of 1099-R, that can often times be a distribution from an insurance company, and it could often times be an investment product like an annuity. For Pennsylvania purposes, if there is a D in box seven of the 1099-R, the contract, the annuity, or the insurance contract is taxable as interest income for Pennsylvania tax purposes.

But as Gail was saying, you get to subtract your contribution from any amount that you collect from that contract, and that is free from Pennsylvania tax to the extent you previously contributed. That's what we call the cost-recovery method. So, if you do get a 1099-R and there's a D in box seven, to the extent of employer contributions and any appreciation in the investment contract, it is taxable. The employee contributions that you would have made towards that investment contract are not taxable, they're tax free because you were previously taxed on that money. You can exclude that portion first, before you report any taxable income from the contract for Pennsylvania purposes.