Tax on a Non-Contributory Retirement Plan

Non-contributory retirement plans, or pensions, provide loyal long-term employees with permanent income for life after retirement. An employee's faithful service is rewarded with a steady, guaranteed paycheck. These types of retirement arrangements, formally known as defined benefit plans, have steadily decreased in popularity due to the significant cost required to maintain them.

If you work for an organization that still offers a traditional pension, you must understand how such a non-contributory retirement plan is taxed while you are employed and after you retire.

Taxation During Accumulation

During the course of your career, your employer will make regular contributions on your behalf to the defined benefit plan. If the plan is entirely non-contributory, no money is deducted from your paycheck to help fund the account. As long as you meet the employer's eligibility criteria for inclusion in the plan, your benefit will continue to increase as long as you continue working. Taxes are not due on the accumulated value of your pension, and you are not entitled to an income tax deduction for any of the money contributed on your behalf.

Taxation During Withdrawal

When you retire and reach the designated age to begin taking withdrawals from your defined benefit plan, you will only owe taxes on the amount of money you receive from the plan in a given year. Non-contributory retirement plans typically do not allow lump sum distributions, but rather provide a consistent and steady stream of income. The aggregate sum of the payments received from your defined benefit plan are added to your taxable earnings for the year, and ordinary income tax rates are applied.

Read More​: Roth IRA Vs. 457

Spousal Continuation of Plans

Many non-contributory retirement plans allow employees to choose a payout option that contractually obligates the employer to continue making pension payments to his spouse after his death. When he passes away, the regularly scheduled monthly income payments may continue until his spouse's death. Ordinary income taxes must still be paid by the spouse for all money received during the year.

Non-Spouse Beneficiaries of Plans

While the bulk of the laws regarding beneficiaries of non-contributory retirement plans surround the employee's spouse, it is important to note that non-spouse beneficiaries are common and are also included in ERISA guidelines. During the course of your career, you may list any beneficiary you choose for the accumulated pension benefits provided by your employer, although most plans require your spouse's consent if you list someone else.

However, once you retire, you may select another beneficiary to receive the balance of your plan assets, assuming you choose a period-certain payout, without the need for spousal consent. If your death occurs prior to the expiration of the guaranteed payout period, your non-spouse beneficiary will receive the remainder of the money, with additional income tax liability for those funds.

There are different ways to leave a non-spousal beneficiary for your pension, and only certain plans allow for it.