Sometimes pension income will be subject to tax. Here is an overview of how pension income will be treated at tax time.
Some companies and government organizations offer a pension to their employees, which usually provides monthly income for life. Your employer will usually fund the plan and then guarantee that you will receive a certain amount upon retirement. When you retire, you will receive a monthly income that can be used to cover your cost of living.
The pension income you receive is often based on the number of years you have worked with the employer, your age and your salary. “The beneficiary can choose to receive their income only during their lifetime,” says Guy Baker, founder of Wealth Teams Alliance in Irvine, Calif. “Or they can choose to take a lower income and guarantee it to themselves and their spouse.”
[See: Jobs That Still Offer Traditional Pensions]
Sometimes pension income will be subject to tax. The exact amount you owe will depend on how your plan is set up, as well as other factors such as where you live.
Here is an overview of how pension income will be treated at tax time.
Is retirement 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’ll be taxed when you receive income from them,” 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 be fully taxable.
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 into a lump sum and turned into an IRA,” says Baker. If you transfer the amount to a traditional IRA, you will pay taxes when you make withdrawals. By transferring the funds into a Roth IRA, you pay taxes 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. “Private and government pension payments are generally taxable at your ordinary income rate,” says Rubio. “Pensions are normally taxed on the federal side.”
In some cases, pension payments will be fully taxable. This can happen if:
— You did not contribute any after-tax dollars to the pension.
— Your employer did not deduct after-tax contributions to the pension plan from your salary.
— You have already received all your after-tax contributions tax-free.
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.
For retirees who start receiving pension payments before age 55, an additional tax of 10% may be applied to the amount. If you qualify for an exception, such as a permanent disability, you may not have to pay this tax.
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. Instead, they are taxed by the state you reside in when the money is distributed. “If you contributed to your pension while living in a high-tax state and move to a state with low or no income tax, you will avoid state tax on your pension income,” says Certified Audience Dennis Duban. accountant and owner of DLD Accountancy in Los Angeles.
Some states do not tax retirement income. These include: Alabama, Illinois, Hawaii, Mississippi and Pennsylvania. Other states don’t tax income at all, so if you live in one, you won’t have to pay state taxes on your pension payments. The states without 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 tax pension income, the amount you pay will vary. Some states only charge taxes on pension income above a certain amount or on 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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How pension income is taxed originally appeared on usnews.com