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The Internal Revenue Code doesn't provide special tax relief for the money you receive from a pension, whether it's a defined benefit plan that provides fixed payments or a defined contribution plan that bases your benefit on the account's investment performance. A lack of special tax relief doesn't mean 100 percent of your pension payments are taxable; it all depends on whether you contribute your own funds to the plan or if it's entirely funded by your employer.
If your pension benefits are paid at regular intervals, such as weekly or monthly, and you'll receive payments for more than one year, each payment you receive is fully taxable if the pension was funded entirely by your employer. In other words, when you don't contribute any of your own after-tax money to the plan, payments are taxed the same way wages are.
When you do make some or all of the contributions to the pension, and you receive payments at regular intervals, the total amount of money you put into the retirement plan is your cost, or investment, that you can recover tax free over the payout period. As you receive pension payments, a percentage of each one is treated as a tax-free recovery of your cost, which means it isn't included in the taxable income reported on your return. To figure out the percentage of each payment that's tax free, the Internal Revenue Service requires you to use the “simplified method.”
The IRS publishes a worksheet -- which you can find in IRS Publication 575 -- that takes you step by step through the simplified method's calculation to figure out how much of your pension benefit is tax free. When filling out the worksheet, you'll need the sum of your annual pension payments, the total investment you have in the plan, the age when you started receiving payments and information about whether the pension will continue making payments to a beneficiary who survives you.
In the first year you're eligible to start receiving your pension, you may have the option of taking a lump-sum payment rather than periodic payments. If you do, the tax-free amount is equal to the lump sum multiplied by a fraction that uses the account balance -- prior to the distribution -- as the denominator and your overall cost, or investment, in the pension as the numerator. For example, if you contributed $100,000 to the pension over the years, the account balance is $1 million and you take a $200,000 lump-sum payment -- $20,000 of it is tax-free.
Just like your salary, pension payments are subject to income tax withholding. You do, however, have the option to request that taxes not be withheld if you provide the institution that administers the pension with Form W-4P. The IRS does require most of your tax bill to be paid during the year as you earn the income and charges penalties if you don't pay most of the tax you owe until you file your taxes. Therefore, if all or some of your pension payments are taxable and you elect zero withholding, you may want to consider making the minimum estimated tax payments to avoid penalties.
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