IRS Tax Treatment of Pensions

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Pensions are retirement plans that are generally structured as a series of payments once you retire from employment. You earn a pension through work, and it is generally based on the years of your service and the compensation you earned. Most workers have a pension through a tax qualified plan, which means it meets certain requirements in the Internal Revenue Code that provide significant tax benefits. There are two types of qualified plans: defined benefit plans and defined contribution plans.

What is a Defined Benefit Plan?

A defined benefit plan is a type of retirement plan that is known as a traditional pension. This type of plan provides employees with a defined benefit at retirement. This means the employee will be able to figure out the amount of the pension at retirement based on an actuarial formula contained in the plan. Employers sponsoring a defined benefit plan carry the risk of investment loss.

What is a Defined Contribution Plan?

A defined contribution plan is a type of retirement plan that is generally known as a profit-sharing or 401k plan. This type of plan does not provide a specific benefit at retirement. The account holder’s benefit will be determined based on the success of the investments in which the account’s assets have been invested at the time the employee retires. The employee bears the investment risk for a defined contribution plan.

Tax Benefit to the Recipient

In general, contributions to a pension are made on a pre-tax basis thereby reducing a participant’s taxable income. Any amount actually distributed to any recipient of a pension from a qualified, tax-exempt trust will be taxable to the recipient in the year it is received. Section 61 of the Internal Revenue Code specifically includes amounts received from pensions. This income will be treated as ordinary income.

Tax Benefit to the Employer

Employers receive deductions for contributions to an employees’ trust or annuity plan. Section 404 of the Internal Revenue Code limits the amount of the deduction that an employer would normally be able to get under Section 162 for ordinary and necessary business expenses since compensation is considered an ordinary and necessary business expense. The employer will receive a deduction in the year it is paid.