Planning a budget for life on a fixed income can be strenuous enough before accounting for taxes. When you receive pension income, you might owe federal taxes on part or all of it as well as state income tax. Generally, if you contributed any after-tax funds to the pension, you recover that amount tax-free. Any investment or growth that hasn’t already been taxed is taxable income when dsitributed. While taxes can vary year to year with political changes, having an idea of how much of your pension income will go to taxes provides you a more accurate figure from which to budget.
The General Rule
If you never contributed a single after-tax dollar to your pension, then the entire amount is considered taxable income. When there’s a mix of after-tax and pre-tax funding, or any untaxed growth, then you must recover the after-tax money proportionally each year. The general rule for pension income excludes a percentage of each payment based on the ratio of your after-tax contributions to the amount you’ll likely pull out of the pension according to IRS tables.
Once you’ve estimated the amount of taxable income you’ll have from each year’s payments, you can estimate the amount of tax you’ll owe based on the current year’s tax tables. Assume the same filing status, but adjust your exemptions and standard deduction for the conditions you anticipate during retirement. For example, if you’ll have a dependent living with you and your spouse when you’re retired assume, you can claim three personal exemptions. Subtract your exemptions and standard deduction from the taxable income from the pension, and find your taxes owed on the tax rate schedule.
Each state sets its own tax laws. Some states attempt to attract retirees by largely or entirely excluding pension income from taxation. Check with your state’s revenue department to find out if and at what rate pension income is taxed, and what deductions apply for retirees. Some states exempt pensions altogether, while others offer large deductions and exemptions. For example, South Carolina provides a $30,000 deduction for married seniors filing joint returns. The top tax rate is 7 percent of taxable income over $14,000 plus $84.
If you contributed $100,000 after-tax and calculate your anticipated return at $300,000, then you would exclude one-third of each payment as tax-free return of principal. If your annual pension income is $42,000, exclude one-third and report $28,000 as taxable income. And if you were married with no dependents, you would subtract $11,900 for the standard deduction as of 2013 and $7,600 for the personal exemptions to arrive at $8,500 in federal taxable income. Your federal tax bill would be $850. Further, if you lived in South Carolina, you would deduct $28,000, and the result would be no taxable income for state tax purposes.
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