Federal Tax Laws on Pensions & Annuities
The laws regarding taxes on pension and annuity income are different if you're on disability, if your pension plan is qualified, if you have a government pension, if you're a current plan participant, if you're a participant's survivor and if you've contributed after-tax income. They also vary based on your age, the reason you're withdrawing, whether you've previously withdrawn from the plan and many other factors. The combination of scenarios this creates makes determining the taxable portion of your pension or annuity income complex. However, the Internal Revenue Service publishes a 45-page document dedicated to this topic with examples to help you determine the taxable portion of your retirement income.
The laws are designed to tax you only once -- either when you contribute or when you withdraw. If you receive pension or annuity payments from a plan in which you did not contribute any money, your employer did not withhold any of your salary as contributions or your contributions were made with pre-tax income, all of the payments are subject to federal income tax and federal income tax withholding. If you paid tax on your contributions or your employer's contributions when either of you contributed them, you don't have to pay tax on the refund of those contributions.
Determining the Taxable Portion
If you began receiving pension or annuity payments from a qualified retirement plan in which you or your employer contributed after-tax money, you must use the simplified method to determine the taxable portion. The taxable portion remains constant until your after-tax contributions have been returned, even if your payment changes. If your pension or annuity payments are from a non-qualified plan, or you begin receiving payments at age 75 that will continue for at least five years, you must use life expectancy tables in the general rule to determine the taxable portion.
Early Withdrawal Penalties
Unless you qualify for an exemption, you might have to pay an additional 10 percent penalty on your pension or annuity withdrawals if you receive them before you turn age 59 1/2. Exemptions include commencing regular withdrawals after you've reached age 55 from a plan in which you no longer participate, withdrawals because you are disabled and withdrawals because the plan participant died. If you are the plan participant's survivor or beneficiary, payments equal to the participant's cost of purchasing the annuity might be exempt from federal tax.
Because there are so many circumstances that affect the taxation of your pension or annuity income, the IRS provides Publication 575, "Pension and Annuity Income." The publication is a 45-page document that discusses the various factors that affect retirement taxation and provides examples to help you determine the taxable portion of your pension or annuity. Read the publication and contact your tax adviser if necessary. If you're age 60 or older, you're eligible for free tax assistance from either IRS-certified volunteers or AARP-affiliated tax aides. The IRS provides contact information for both groups in Publication 575.
Steve McDonnell's experience running businesses and launching companies complements his technical expertise in information, technology and human resources. He earned a degree in computer science from Dartmouth College, served on the WorldatWork editorial board, blogged for the Spotfire Business Intelligence blog and has published books and book chapters for International Human Resource Information Management and Westlaw.