Are pension benefits taxable?

Whether your pension benefits are taxable depends on several factors. Your pension benefits can be fully or partially taxable depending on how and when you contributed to the fund. It is also important to note that employer-funded pensions are treated somewhat differently than IRA and 401(k) accounts.

When Pension Benefits are Fully Taxable

Generally, your pension benefits are fully taxable if you did not contribute anything to the pension or annuity and your employer did not withhold contributions from your salary. If your employer made all the payments to your pension fund, you must report that amount on your tax return. It will be included in the total amount you owe in federal income tax. Pension benefits are also fully taxable if you received all your contributions tax-free in earlier years.

When Pension Benefits are Partially Taxable

If you contributed after tax dollars to the pension, those funds are not taxable. So the portion of your pension benefits that came from after-tax dollars cannot be taxed a second time. You will pay taxes on any pre-tax contributions.

Regardless of whether your contributions would be fully or partially taxable under Internal Revenue Service (IRS) rules on pensions, early retirement comes with a penalty. If you retired before age 55, then your pension could be subject to a ten percent early distribution tax. There are some exceptions for illness and disability, but most people would pay the early distribution penalty.

How to Calculate Taxable Portions

Calculating the taxable portion of your pension or annuity will vary depending on the year you began receiving payments. If your distributions began on or before November 18, 1996 then you have to use the General Rule. This rule is based on life expectancy charts produced by the IRS. The process can be difficult, which is why the IRS offers to calculate the correct tax amount for a small fee. People whose distributions began after November 18, 1996, may use the Simplified Method, taken from a worksheet available on the IRS website.

Understanding IRA and 401(k) Accounts

Though slightly different from employer funded pensions, 401(k) accounts receive similar treatment. Any employer matching funds and pre-tax funds withheld from your paycheck are fully taxable. Any contributions you make after taxes are not taxable.

If you are receiving pension benefits from an individual retirement account (IRA), they are not taxable because IRAs are funded through after-tax contributions. Once you retire, IRA benefits are generally taxable in the year you receive them. Similar to pension recipients, IRA holders that begin to make withdrawals before age fifty nine and a half will have to pay a ten percent early withdrawal penalty. However, the additional ten percent tax may not apply if the withdrawals are made after separation from employment in or after the year the recipient reaches age fifty five.

Getting Help

If you need help determining which portion of your pension benefits are taxable, consider speaking with a pensions and benefits attorney. If you are having trouble collecting your pension, a pensions and benefits attorney can also assist you with any actions that need to be taken such as composing a demand letter or filing a claim.