If you've been working for most of your adult life, you may have worked for an employer who agreed to pay you a pension in retirement. These funds can go a long way toward ensuring that you live comfortably in retirement, and they may serve as a large component of your retirement plan, but do you pay taxes on pension income?
According to the IRS, if you receive a pension from your employer, all or some of that pension likely qualifies as taxable income. Any portion of your pension income funded by pretax contributions will require you to pay taxes on it, while any after-tax contributions will return to you tax-free.
To help you plan your retirement finances appropriately, let's walk through how much of your pension may count as taxable income.
What Is a Pension?
Pensions, formally called defined-benefit plans, act as a guaranteed source of monthly income in retirement. The amount you can expect to receive will depend on a number of factors, such as your age, years of service with your employer and compensation.
These plans have the employer bear all of the risk in terms of responsibility for funding the plan, selecting the plan's investments and ensuring that you receive your guaranteed income. Not all employers offer pensions, but most government organizations do provide them as a retirement benefit.
When Do You Pay Taxes on Pension Income?
Two sources of contributions can fund your pension: pretax contributions made by you or your employer on your behalf, and after-tax contributions that come directly out of your paychecks. Pension income counts as fully taxable income and is subject to ordinary income tax rates if the contributions come entirely from pretax dollars.
However, pension income counts as partly taxable when contributions also come from after-tax dollars. You do not need to pay taxes on the portion of your pension income that represents a return of your after-tax contributions, as you already paid taxes on this income before making contributions to your pension plan. Taxing these contributions again would constitute double taxation.
In other words, if you or your employer makes a contribution to your pension plan with your after-tax income and you don't claim a tax deduction, you won't need to pay taxes on that portion of your pension income. You will, however, pay tax on the tax-deferred earnings that these after-tax contributions accrue, as well as any pension income funded by pretax contributions.
To understand how the taxable portions of your pension income can affect your tax bill, you will need to consider either the General Rule or the Simplified Method from the IRS.
The General Rule
According to the IRS's General Rule on pension income, you must figure the taxable and non-taxable parts of your pension income by using life expectancy tables from the IRS. The math can get complicated, which is why the IRS offers to calculate your taxable pension income under this rule in exchange for a nominal fee. It can also be helpful to discuss tax implications with a tax professional, who can walk you through your specific situation.
If your state pension date occurred or will occur after November 18, 1996, however, you will generally use the Simplified Method to determine the taxability of your pension income.
The Simplified Method
The IRS named the Simplified Method because, compared to the General Rule, the Simplified Method's process for determining the taxable and tax-free portions of your pension income tends to be much easier. The IRS provides guidance and an example in their Simplified Method Worksheet, though it may be helpful to walk through this with a tax professional.
Summing Up the Tax Implications of Pensions
As a general rule, if you contribute after-tax money to your pension, this portion of your pension usually comes back to you tax-free. However, any pretax contributions that you make or earnings that your after-tax contributions accrue will usually be subject to taxes.
In short, most pension income requires you to pay tax on it. To ensure that you don't owe taxes unexpectedly, you can often let your pension plan providers know that you want taxes withheld from your pension payment. Speaking with a financial advisor can also help you make the right decisions based on your unique financial needs and retirement goals.