How to Calculate a Pension's Taxable Amount

A pension is a traditional and powerful foundation on which to retire. Many workers toil long and hard at their jobs while looking forward to the day when they will rest from their labors and receive the fruits of decades of effort. Yet, a pension comes with a burden of its own: income tax.

In most cases, pensions are funded with pre-tax dollars that remain protected from government assessment until they are paid out to the retiree. Unless the pension holder is independently wealthy, it is a good idea to understand how much of the outlay goes to the IRS.

How Does a Pension Work?

A pension plan is a coveted benefit that some employers offer to their workforce. In essence, a pension is a financial account that the employer contributes to during the course of an associate's service with the company or agency.

To be clear, the burden of building a pension is on the employer. This, in part at least, explains why pension plans have gradually waned over the last half-century. They are a major expense for a company to shoulder. Based on the associate's salary/wage and years of employment, payments can be quite generous in some instances.

How to Qualify for A Pension

Pensions can be a defined benefit, where the employer guarantees a fixed monthly payment upon retirement, independent of ebbs and flows in the economy. Alternatively, the organization can commit to a defined-contribution plan, whereby a specific amount is deposited on a regular basis to the worker's pension fund, to which the employee may also contribute, but money disbursed is conditioned on how well the fund is performing. Having fulfilled its obligation on the front end, the company is not liable if the payments begin to shrink.

Older, more traditional pensions are defined-benefit whereas defined-contribution funds are more akin to the more popular (with employers) 401(k) plan. To enjoy pension benefits, an employee must be vested, surpassing a minimum number of years on staff.

Figuring Out Taxable Pension Income

While the government may tax interest on a savings account, there would be a large hue and cry if deposits themselves were levied since the deposited dollars may have already been taxed as income. So, it is important to differentiate employer contributions from employee additions when learning how to calculate tax on pension income. The IRS recognizes just two approaches as legitimate and acceptable ways to determine this.

The IRS General Rule for Pensions and Annuities applies to private annuities and "non-qualified" retirement plans, or if the annuity starting date is subsequent to 1996.

Try the Simplified Method

Most people retiring now are eligible to utilize the Simplified Method, as long as they are under ​75 years​ of age when payments begin.

The simplified method is striking in its simplicity. Add up the total amount of contributions that had been previously taxed (make sure to document this), take the sum and divide it by the number of payments you anticipate receiving. The Simplified Method worksheet helps to determine this divisor with a chart that references age and marital status before and after November 20, 1996.

What does such a calculation look like? For example, assume a retiree was 56 as of November 20, 1996, and married at the time. In this event, ​260 payments​ are expected over the course of retirement.

If that same person contributed $5,000 in contributions that were taxed prior to their inclusion in the pension fund, then that amount is divided by 260. Therefore, $19.23 of each pension payment is exempt from being taxed. The remainder, of course, is categorized as taxable income.