Are pension benefits taxable?
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The answer is “it depends”— on when and how you contributed to your pension. Depending on how contributions were made and by whom (e.g., by your employer or by you), your pension may be fully taxed, partially taxed, or not taxed at all.
Also, the type of pension or retirement account matters: employer-funded pensions are treated somewhat differently than IRA and 401(k) accounts.
And when you retire makes a difference, too, as far as when you can began taking the money.
When Pension Benefits are Fully Taxable
There are two situations where your pension is taxable:
(1) As a general matter, your pension benefits are fully taxable if you did not contribute anything to the pension or annuity. That is, pensions funded by another (i.e., your employer) are taxable in the same way that wages paid to you by your employer are taxed. This includes the situation where your employer did not withhold contributions from your salary for your pension or retirement account. Money withheld from your pay is your own money, even if the employer managed or administrated the process of withholding for you. If your employer made all the payments to your pension fund, you must report that amount on your tax return and pay the tax due when you file the return for the year.
(2) Pension benefits are also fully taxable if your contributions to the pension were tax-free in earlier years. In this situation, which is common with 401(k) and traditional IRA accounts, you get a tax break up front, when you pay in. The income you contribute is excluded from taxation. But you pay taxes on the backend, once you start taking out income from the fund after retiring.
When Pension Benefits are Partially Taxable
If you contributed after-tax dollars to the pension (i.e., money you did not receive a tax break on when contributing), those funds are not taxable. The portion of your pension benefits that came from after-tax dollars cannot be taxed a second time, and you will only pay taxes on any pre-tax contributions (on the money on which you received a tax break when you made your contributions).
Regardless of whether your contributions would be fully or partially taxable under Internal Revenue Service (IRS) rules on pensions, early retirement comes with a penalty. If you take a withdrawal under age fifty-nine-and-a-half, you will ante up an additional 10% early withdrawal penalty on the amount of the withdrawal. There are some exceptions for workers leaving/losing a job at age 55 or later, or due to illness and disability, but most people would pay the early distribution penalty. Working an extra year or three, even if you don’t otherwise need to, may pay large dividends.
How to Calculate Taxable Portions
The taxable portion of your pension or annuity will vary depending on the year you began receiving payments. If your distributions began on or before November 18, 1996, then you have to use what is called the General Rule, which is based on life-expectancy charts produced by the IRS. The calculations can be difficult, which is why the IRS offers to calculate the correct tax amount for you for a small fee. (Who says government isn’t helpful?)
On the other hand, people whose distributions began after November 18, 1996, may use the Simplified Method, taken from a worksheet available on the IRS website. (No, this differential treatment isn’t fair—but it is the law.)
Understanding IRA and 401(k) Accounts
401(k)s: Though slightly different from employer-funded pensions, 401(k) accounts receive similar treatment to those pensions. Any employer matching funds and pre-tax funds withheld from your paycheck are fully taxable, while any contributions you make using after tax dollars are not taxable.
Traditional (non-Roth) IRAs: Similar to your (the employee) portion of 401(k) contributions, the contributions you make to a traditional IRA give you a tax advantage in the year you make them.
But as an old saying goes, “There ain’t no free lunch.” If you get your tax break up front, you pay for it on the backend: once you retire, traditional IRA benefits are generally taxable in the year you receive them.
And also similar to pensions, there is an early-withdrawal (basically early retirement) penalty. IRA holders who begin to make withdrawals before age fifty-nine-and-a-half will have to pay a ten percent (10%) early withdrawal penalty. However, the additional ten percent tax may not apply if the withdrawals are made after separation from employment (whether retiring or being terminated or laid off) in or after the year the recipient reaches age fifty-five.
Roth IRAs: essentially the reverse of traditional IRAs—you pay your taxes upfront (there is no tax break or advantage on contributions to the Roth IRA), but then your benefits are tax-free when you withdraw them.
There are key differences between traditional IRAs and Roth IRAs when it comes to eligibility, withdrawal, and tax treatment. If you have questions, the handy chart on the IRS website provides a useful starting point in comparing the two IRAs.
Getting Help—IRS Pitches in
Your pension and various other retirement income are reported on 1099-R.
The 1040 return form has a worksheet to calculate the pension tax amount owed during the year. (If you filed the information in past years on Form 1040A, you now will use going forward the new Form 1040 instead.) The amount of the IRA and pension distributions is plugged in on Lines 4a and 4b.
If you need help determining which portion of your pension benefits are taxable, consider speaking with a pensions and benefits attorney. If you are having trouble collecting your pension, a pensions and benefits attorney can also assist you with any actions that need to be taken, such as composing a demand letter or filing a claim.