Funds in your pension plan typically consist of pretax dollars, meaning you'll need to pay taxes on all of the money once you start receiving payments in retirement. In some cases, though, you might have already paid taxes on a portion of the funds, if you made after-tax contributions to your plan while still working. To figure out the taxable and non-taxable portions of your pension payments, the IRS requires that you use one of two different methods, the General Rule or the Simplified Method.
Pension plans are retirement benefit plans provided through an employer, typically paying regular payments during an individual's retirement to help replace a paycheck. The payments come from an investment fund that the individual, or his employer, contributed to during his working years. Pension payments factor in an employee's prior compensation and years of service to his employer.
Fully vs. Partially Taxable Funds
The payment amounts you receive from your pension are fully taxable if you made no investment in the contract, and you'll receive an IRS Form 1099-R each year showing the total distribution you've received. Many pension programs are fully funded by employers. If you did not make any contributions to your pension with after-tax dollars, or if you received your contributions on a tax-free basis in prior years, all of your pension income will be taxable.
Conversely, you won't pay taxes on a portion of your pension payments if you made contributions to your account with after-tax dollars. In other words, you don't have to pay taxes twice on the part of your contributions or payments that consist of a return of these after-tax payments made during your working years.
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The General Rule Method
For non-qualified pension plans, you must use the General Rule method to figure out the taxable and tax-free portions of your pension payments. IRS Publication 939, General Rule for Pensions and Annuities, provides the calculation and other required information to help you figure your taxable portion. The formula is fairly straightforward if you expect to get payments for a set number of years. However, if you expect payments for the rest of your life, you'll need to also use a factor from the actuarial tables provided in Publication 939.
The Simplified Method
Individuals with pensions started after November 18, 1996, must generally use the Simplified Method to calculate the taxable and non-taxable portions of their pension payments. However, if you're 75 or older, and your annuity or pension payments are guaranteed for more than five years, you'll still need to use the General Rule method.
You can complete the Simplified Method worksheet, located in the IRS Form 1040 Instruction book, for lines 16a and 16b, or Form 1040A Instructions for lines 12a and 12b. You can also use the worksheet in the back of IRS Publication 575, Pension and Annuity Income. You'll need to know your total payments received for the year, any investment you've made in the pension, and any amounts you've recovered tax-free in prior years. The IRS workbook provides a step-by-step formula, including a table of numerical divisors to account for the age when you started taking payments, and the date your pension plan started payments.