A pension is an employer-created retirement account from which payments are made to you after you retire. Some plans permit you to either accept a lump sum payment upon retirement or receive monthly payments for the remainder of your life. The amount of payment is generally based upon years of service and how much you made during your employment.
Whether pension distributions count as income on your taxes depends upon whether the distribution is considered taxable. While certain types of retirement accounts will provide you with tax-free income after you retire, pension distributions are taxed depending upon the type. After the tax year ends, you will receive a Form 1099-R to file with your taxes and show which amounts are taxable and which amounts are not.
Paying Tax on Pension Income
Income from most pensions is taxable. Generally, your pension distributions are taxable income if:
- You didn't contribute any of your own funds to the pension.
- Your employer didn't withhold any funds from your paycheck to fund the pension.
- If you did make contributions, they were distributed back to you tax-free in the years prior to your retirement.
You can choose to have taxes withheld from your pension distributions.
Pensions and Partial Taxes
Some pension plans distribute income that is taxable in part and non-taxable in part. If you make contributions from your own funds to a pension, this is called your investment in the contract. Your investment in the contract will be paid back to you after you retire as part of your pension distribution, and that portion is not taxable if the contribution was made from your take-home pay and not your gross pay. Because that contribution is coming out of your take-home pay, you've already paid taxes on it.
Therefore, if you contributed after-tax dollars to your pension during your employment, when you retire, the portion of your monthly payment that relates to your contributions will generally not be considered taxable income. For example, if your monthly pension payment after retirement is $1,000, and $200 of that amount represents your own after-tax contributions, you will be taxed only on $800.
Read More: Can You Roll Over a Pension Plan Into an IRA?
Tax Credits for Disability Pensions
If you receive a pension because you are disabled, your pension distributions are reported as wages until you reach retirement age. After you retire, they are reported as pension income. However, if you are permanently and totally disabled when you reach retirement age, you may be entitled to a tax credit to offset the tax. If you receive disability pension distributions because you were injured in a terrorist attack directed against the United States or its allies, your pension income is not taxable income.
It's worth noting that Social Security benefits and pension income are not viewed the same by the IRS. The taxable income definition can include both, but the criteria for including them is different.
Military and Government Disability Pensions
If you receive a military disability pension or a government disability pension, the distributions may not be taxable. You may be able to exclude disability payments you receive if you were injured or became ill because of active service in any of the armed forces, or if you were injured or became ill because of active service in the National Oceanic and Atmospheric Administration, the Public Health Service or the Foreign Service.
Read More: VA Disability Rating Guideline
Understanding the Early Distribution Penalty
If you receive any pension payments before you reach the age of 59 1/2, you may have to pay an extra 10 percent tax on those payments. The penalty does not apply to distributions that are:
- Made as part of a series of substantially equal periodic payments that begin after you leave your job
- Made due to permanent or total disability
- Made on or after the plan participant's death
- Made after you leave your job and in or after the year you turn 55 years old
For 2020, the CARES Act waves the 10 percent penalty for early withdrawals of up to $100,000 from your pension, so long as the funds were used for a valid Covid-19 related reason.
- IRS: Tax Topic 410 - Pensions and Annuities
- IRS: Publication 575 (2019) - Pension and Annuity Income
- The Motley Fool: Is Social Security Taxable?
- Financial Finesse: Penalty-Free Retirement Account Withdrawals Under the CARES Act – FAQs
- U.S. Department of Labor. "Types of Retirement Plans." Accessed July 25, 2020.
- Department of Labor. "What You Should Know About Your Retirement Plan," Page 4. Accessed July 25, 2020.
- Department of Labor. "FAQs about Retirement Plans and ERISA," Page 4. Accessed July 25, 2020.
- Internal Revenue Service. "Topic No. 410 Pensions and Annuities." Accessed July 25, 2020.
- Internal Revenue Service. "Publication 575 (2019): Pension and Annuity Income," Page 6. Accessed July 25, 2020.
- Department of Labor. "What You Should Know About Your Retirement Plan," Page 6. July 25, 2020.
- Department of Labor. "FAQs about Retirement Plans and ERISA," Page 12. Accessed July 25, 2020.
- Pension Benefit Guaranty Corporation. "Your Guaranteed Pension: Single-Employer Plans." Accessed July 25, 2020.
- Social Security Administration. "The Disappearing Defined Benefit Pension and Its Potential Impact on the Retirement Incomes of Baby Boomers." Accessed July 25, 2020.
- Department of the Treasury. "Treasury Issues Final Rules Regarding Longevity Annuities." Accessed July 25, 2020.
- IRS. "IRA Deduction Limits." Accessed July 25, 2020.
Rebecca K. McDowell is an attorney focused on debts and finance. She has a B.A. in English and a J.D. She has written finance and tax articles for Zacks and eHow.