How Pension Income Is Taxed
Learn what to expect in taxes if you receive a pension in retirement.
It's important to understand the tax implications when you start receiving pension income.(Getty Images)
Some companies and government organizations provide a pension to their employees, which typically provides a lifetime monthly income. Your employer will usually fund the plan and then guarantee that you will receive a certain amount during retirement. When you retire, you will get a monthly income that can be used to support your cost of living.
The pension income you receive is often based on the number of years you spend with the employer, your age and your salary. “The recipient can select to receive their income during their lifetime only,” says Guy Baker, founder of Wealth Teams Alliance in Irvine, California. “Or they can elect to take a lower income and have it guaranteed to both themselves and their spouse.”
Sometimes the pension income will be subject to tax. The exact amount you owe will depend on the way your plan is set up, along with other factors such as where you live.
Here’s a look at how pension income will be treated at tax time.
Is Pension Income Taxable?
Whether the money you receive from a pension is taxed depends on how it was first contributed to the account. “Most pensions are funded with pre-tax dollars, which means you will be taxed when you receive income from it,” says Rafael Rubio, president of Stable Retirement Planners in Southfield, Michigan. For pensions that are funded with dollars that have already been taxed, the money that is distributed may not all be subject to tax.
While many pensions are set up to provide monthly payments, there may also be other distribution options. “In some cases, the pension can be converted to a lump sum and rolled to an IRA,” Baker says. If you roll the amount into a traditional IRA, you will pay taxes when you make withdrawals. By rolling the funds into a Roth IRA, you pay tax on the money up front and then withdraw the funds tax free.
Read:How to Find a Lost Pension Plan. ]
How Pensions Are Taxed
When you start receiving pension income, it’s important to understand the tax implications. “Payments from private and government pensions are usually taxable at your ordinary income rate,” Rubio says. “Pensions are normally taxed on the federal side.”
In some cases, the pension payments will be fully taxable. This can occur if:
- You didn’t contribute any after-tax dollars to the pension.
- Your employer didn’t withhold after-tax contributions to the pension plan from your wages.
- You’ve already received all your after-tax contributions in a tax-free way.
In other situations, your pension payments will be partially taxable. This can happen if you contributed after-tax amounts to your pension. You won’t be charged taxes on the part of the payment that represents the after-tax portion you paid in.
For retirees who begin receiving pension payments before age 55, there could be an additional 10% tax applied to the amount. If you qualify for an exception, such as a permanent disability, you may not have to pay this tax.
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How States Tax Pension Payments
Depending on where you live, your state may tax pension income. Pensions are not taxable by the state in which the money was earned. Rather, they are taxed by the state where you are a resident when the money is distributed. “If you contributed to your pension while living in a high tax rate state and you happen to move to a state with low or no income tax taxes, then you will avoid state tax on your pension income,” says Dennis Duban, a certified public accountant and owner of DLD Accountancy in Los Angeles.
Some states don’t tax pension income. These include: Alabama, Illinois, Hawaii, Mississippi and Pennsylvania. Other states don’t tax income at all, so if you live in one of them, you won’t have to pay state taxes on your pension payouts. The states with no income tax are: Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. New Hampshire only taxes dividend income and capital gains.
In states that charge taxes on pension income, the amount you pay will vary. Some states only charge taxes on pension income that is above a certain amount or to people who earn more than a specific adjusted gross income. Other states have exclusions for government retirement income, military-related payments, railroad retirement income and teacher benefits.
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