You’ve worked hard all your life, and now you’re finally retired. But one question that is nagging at you – is your pension taxable?
It’s normal to have a lot of questions about retirement, especially when it comes to money. Whether or not it will be taxed.
With this simple guide on retirement and taxes, we’ll help clear things up for you. In this guide, we’ll answer the most common questions people have about their pensions and taxes.
In addition, we’ll give you tips on how to reduce the amount of taxes you pay on your retirement income.
So, let’s jump into it without further ado!
Is Pension Taxable? Yes, pension is taxable as ordinary income. This means that pension payments are taxed at the same rate as your wages and salaries. Pensions are generally taxable at the federal level. However, there are a few exceptions. For example, some states, like Alaska, Florida, Texas, Washington, do not tax pension payments.
Is Pension Taxable?
Yes, Pension income is generally taxable. However, there are some exceptions. For instance, portions of your pension may be excluded from taxation if you contributed to a qualified retirement plan. If you made contributions after-tax but did not take a tax deduction, you are not taxed at the time of distribution.
If you withdraw the pre-tax money you contributed, it will be taxed. Usually, pension accounts are funded with pre-tax money, so the government will count all of your annual pension income as taxable income each year that you take it. To offset the hit at tax time, you can ask that taxes be withheld directly from your pension check.
How much of your pension is taxable will depend on the type of pension you receive and your individual tax situation. Typically, however, most of your pension income will be subject to taxation.
Types Of Pension
There are two common types of pension: defined benefit plans and defined contribution plans.
Defined Benefit Plans: A defined benefit pension plan is a retirement plan that promises a certain monthly payment. This payment is usually an exact dollar amount, like $100 per month. However, sometimes the payment is calculated using a formula that considers factors such as salary and years of service. For example, 1 percent of average salary over the last five years of employment for every year of service.
In most traditional defined benefit plans, the benefits are protected, within certain limits, by federal insurance that is offered through the PBGC (Pension Benefit Guaranty Corporation).
Defined Contribution Plans: A defined contribution plan does not guarantee a specific amount of retirement benefits. These plans allow employees or employers (or both) to contribute to an individual account under the plan, sometimes at a set rate, such as 5 percent of earnings.
In most cases, contributions are invested on behalf of the employee. As a result, the employee will receive the balance in their account, which is based on their contributions plus or minus investment gains or losses. Due to changes in the value of the investments, the value of the account will fluctuate.
The following are some examples of defined contribution plans:
- 401(k) plans
- 403(b) plans
- employee stock ownership plans
- And profit-sharing plans.
Ways To Reduce The Amount Of Tax Owed On A Pension Plan
There are a few ways to reduce the amount of taxes you owe on your pension. Planning ahead is the best way to minimize taxes in retirement. Before your retirement date, you should meet with a financial advisor who specializes in retirement planning.
An experienced retirement planner can advise you on how to fund your retirement and minimize taxes. Even if you’re close to retirement, or already retired, seeking advice from an expert won’t hurt.
Another way is to contribute to a retirement plan such as a 401k or IRA. These plans allow you to deduct your contributions from your taxable income, which can save you a lot of money in taxes. Additionally, you may be able to reduce your taxable income by claiming certain tax deductions and credits.
Calculating Taxes On Pension
The taxes on a pension depend on a few factors: the amount of the pension, your income tax bracket, and whether you’re taking the taxable or nontaxable portion of the pension. You can use the IRS worksheet to help calculate taxes on pensions.
Depending on the timing of the starting date of your plan, you can choose either the general rule or the simplified method to calculate taxes.
If your annuity or pension payments began before November 18, 1996, you use the General Rule. If your pension or annuity payments began after that date, you can use the Simplified Method to calculate the taxable portion.
The Simplified Method
The simplified method is a calculation tool provided by the IRS that helps taxpayers determine the amount of tax they owe on their pension income. This method is based on your filing status, taxable pensions and annuities, and adjustments to income.
If your annuity or pension payments started after November 18, 1996, you can use the Simplified Method to determine how much pension payment is taxable and taxable-free. To assist you, the IRS provides a Simplified Method Worksheet.
To calculate your taxes on pension using the simplified method, follow these steps:
- Calculate your taxable income by adding up all of your income (pension plus any other sources of income) and subtracting any applicable deductions or exemptions.
- Find the tax bracket that corresponds to your taxable income.
- Multiply your pension amount by the tax bracket percentage to find your tax liability.
- Add together all of your other taxes (e.g., state taxes, federal taxes, etc.), and subtract this from your total tax liability to find how much you owe in taxes on your pension alone.
The General Rule
To calculate the taxable and tax-free portions of your payments, you must use the “actuarial” tables provided by the IRS. You’ll find them in IRS Publication 939, General Rule for Pensions and Annuities. Also, this publication explains how to calculate your taxable pension and annuity under the General Rule.
If you’d like the easiest option and accurate calculations, consider having a tax professional or having the IRS make these calculations for you.
How To File Taxable Pension On Your Federal Taxes
Pensions can be quite complex when it comes to taxes. Pensions that are taxable require you to file IRS Form 1040. When you receive 1099-R statements, separate them into two piles: IRA statements and pension or annuity statements.
Now you need to report your IRA distributions on lines 4a and 4b of the 2021 Form 1040. On lines, 5a and 5b, report your pension and annuity distributions. The ‘a column’ represents the total distribution and the b column separates the taxable amount.
Annual tax returns may differ from these lines in the previous year. Since 2017, the IRS has revised Form 1040 a number of times. Depending on the tax year, these appropriate lines can differ. If you file your tax return in 2022, these lines will apply to your 2021 tax return.
For more information, it is best to speak with an accountant or tax specialist in your area.
State Taxes On Pension
Taxes on pension income vary from state to state. Make sure to check the different state taxes on pension income. Depending on the state, some states do not tax pension payments while others do—and that can influence people to consider moving when they retire.
If you’ve moved your legal residence to another state, then you can’t be taxed on pension payments you earn within their borders. For example, if you worked in Minnesota, but currently live in Florida, which does not have state income taxes, you won’t have to pay Minnesota income taxes on the pension you receive from your former employer.
The following are some states where you don’t have to pay taxes on 401(k), IRA, or pension income:
- Alaska
- Florida
- Illinois
- Mississippi
- Nevada
- New Hampshire
- Pennsylvania
- South Dakota
- Tennessee
- Texas
- Washington
- Wyoming
Conclusion
So, is your pension taxable? The answer is a typical yes, pension is taxable. The amount of tax you owe on your pension depends on your income and filing status. However, there are a number of deductions and exemptions that may lower the amount of tax you owe on your pension.
Consult with a qualified tax professional to find out how much of your pension is taxable and to get tips on how to reduce the amount you owe.