It would be nice if once you retired and stopped worrying about work, you could also stop worrying about taxes. But life’s just not that simple. If your retirement plans include pension income, you'll probably need to pay the tax man on that income, although in some situations the entire pension payment isn’t taxable.
Employer-sponsored pensions are one of the most common retirement pensions. In these pensions, you receive pension payments from your former employer after you retire, and you don’t need to contribute any of your own income to the fund. For tax purposes, the easiest way to think about these pensions is as though your employer is delaying paying a portion of your compensation until you retire, at which time you’ll continue receiving paychecks. Because of this, the Internal Revenue Service treats these pension payments as income, and they’re fully taxable.
Pretax Employee Contributions
Some pension plans allow you to contribute a portion of your compensation to the pension fund before the IRS assesses income taxes, thus lowering your adjusted gross income and reducing your federal tax bill in turn. If your pension includes pretax contributions from your paycheck, the IRS treats your pension in much the same way as if you made pretax contributions to an IRA: Your pension payments are fully taxable, because you deferred taxes in the year you earned the contribution.
After-Tax Employee Contributions
If you contributed after-tax funds to your pension fund while you were working, the IRS allows you to receive a portion of your pension tax-free, as you previously paid income taxes on contributions. The IRS provides two calculations – the General Rule and the Simplified Method – for determining what portion of your pension is tax-free. How you contributed, and when you began drawing your pension, determine which calculation you use. Although the mechanics of these methods differ, both determine how much of the overall pension amount you contributed after tax, and they exclude that amount from taxation.
Many pension managers offer retirees the option of receiving their pension in a lump-sum payment of the full value of their pension account rather than recurring annuity payments. These lump-sum payments are subject to the same rules that govern the taxation of pension payments. However, if you receive a large lump-sum payment, it might increase your adjusted gross income enough to put you in a higher tax bracket. In that case you'd pay more tax than if you received smaller, periodic payments.
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