Pensions are an excellent benefit that gives you an income during your retirement years, but there can be tax consequences of which you need to be aware. Whether your entire pension is taxable or only a part of your pension is taxable depends on how your employer sets the account up.
Rules for taxes are different for pensions than for other retirement income. Knowing your tax liability on your pension is an important factor in calculating how much you will receive.
Taxes by Contribution
One factor that determines whether your pension is taxable is how much you contributed pre-tax. In some cases, you might not contribute to your pension at all, but your employer continues to make contributions on your behalf. If your employer made all of the contributions and did not withhold any taxes from them, then the entire amount you receive will be taxable.
In some cases, a portion of your pension will be tax-free and a portion will be taxable. If you contributed after-tax dollars to your pension, you will get credit and this portion will not be taxed because taxes have already been paid. Any earnings that you made on your contributions will be taxed. To calculate your taxable portion, the IRS has developed what is known as the Simplified Method.
Calculating Taxable Portion of Pension
To calculate how much of your pension is taxable and how much taxes you owe, many people can use the Simplified Method Worksheet. This sheet allows you to prorate your contributions toward the pension plan over your expected lifetime. Using this method, you can have a portion of your pension tax-free and you can carry forward any unused tax credits into the following year.
The IRS also has an alternative method called the General Rule that can be used to calculate the amount of taxes you will owe on your pension. When you receive your Form 1099-R, the taxable amount should be shown in Box 2a. If it is not, you might need to consult IRS Publication 575 and Publication 939 to calculate the taxable portion of your pension that should be entered onto your Form 1040.
If your annuity started before July 1, 1986, you might be required to use the Simplified Method to figure the taxable portion of your distribution.
Using the Simplified Method
Certain rules apply to who can use the Simplified Method for the calculation of the taxable portion of your distribution. First, you must be enrolled in a qualified retirement plan. You cannot use the Simplified Method if you are age 75 or older. Also, your annuity must be for a specified number of payments to use this method. If your annuity or your age disqualifies you from using the Simplified Method, you must use the General Rule instead.
For calculations using the Simplified Method, the annuity starting date is the first day you begin receiving payments. You need to be aware that there are special rules for survivors and survivor’s benefits. If your annuity is variable, or you do not receive the payments on a regular schedule, then you must use the General Rule and cannot use the Simplified Method. Other rules apply that depend on the type of annuity, all of which are explained in IRS Publication 939.
If you have a pension and other forms of retirement income, or your spouse has additional income, you need to determine which is taxable and which is tax-free. IRS Publication 4190 explains the difference between taxable and non-taxable retirement income. If you have any questions about whether you can use the Simplified Method or how the Simplified Method applies to you, you can contact the IRS or a tax professional for further information.
- If the annuity is not a qualified plan, you can't calculate the taxable portion using your age and the simplified rule. You'll have to calculate the taxable portion for this type of annuity based on your expected return.
Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.