When making retirement decisions, it’s not only critical to document every source of future retirement income, but also to know whether that income is taxable in retirement. From that information, you can determine when and where to retire. Is your pension taxable, either at the federal or state level? You can’t do much about the former, but you have more say in the latter if your current state isn’t pension-friendly by moving to a state that doesn’t tax pensions.
IRS General Rule for Pensions and Annuities
Anyone receiving retirement benefits in the form of either pension or annuity payments may have all or some of his income taxed, as per the IRS. If you didn’t contribute monies toward your pension, or your employer didn’t withhold pension contributions from your paycheck, expect to pay federal taxes on your pension at ordinary income rates.
The majority of pensions are funded with pretax dollars. If your pension contributions were tax free, the IRS considers your pension fully taxable. The taxes are deferred until retirement and you begin making withdrawals. Many retirees fall into a lower tax bracket after retirement, so it’s likely your ordinary income rate will drop.
If your pension contributions were made with after-tax funds, your pension income is partly taxable. The IRS does not consider taxpayers responsible for paying taxes on the part of their pension income constituting a return of their after-taxes payments. While the after-tax payments are viewed as employee investments in the pension contract, this also holds true for employer pension contributions, taxable for the employee.
Pensions and Retirement Age
If you begin receiving pension payments before reaching age 59 1/2, you must pay a 10 percent tax on your distributions. The IRS has similar rules for other employer-sponsored retirement plans and traditional IRAs.
There are exceptions, primarily if the recipient took the pension early because of total and permanent disability. The IRS also makes an exception if the recipient leaves her employer and the distributions are part of “a series of substantially equal periodic payments.” If the distributions were made in the year the individual turns 55 or older and there has been separation of service, there is no penalty.
States With No Pension Tax
Unfortunately, most states will tax at least part of your pension income, if not the entire amount. Fourteen states won’t tax your pension, and that’s a consideration if you are thinking of living elsewhere in retirement and your pension makes up a large source of your income. These states include:
- New Hampshire
- South Dakota
Some of these states don’t have a state income tax. Before you pack up and move, however, make sure you research every aspect of how a state taxes retirement and other income. Relatively few states tax Social Security benefits.
Many states levy income tax on distributions from IRAs and employer-sponsored retirement plans such as 401(k)s. If you’re married and your spouse receives most of her retirement income from a 401(k), it may affect your decision. Do the math before calling the realtor.
Senior Property Tax Exemptions
If you own real estate in retirement, you’ll have to pay property taxes, but some states offer property tax exemptions for those ages 65 and up. Eligible seniors may have to meet income limits. States offering a certain amount of property tax exemptions to seniors include:
- Alaska with statewide municipal tax exemptions for seniors
- Florida with some municipalities offering additional homestead exemptions for seniors
- New Hampshire with exemptions for seniors who are residents for at least five years
The Tax Bite of Other Income
You may have other retirement income besides your pension, and if you’re married, you must also consider how your spouse’s retirement income will fare at tax time. If this additional income includes an employer-sponsored retirement plan or a traditional or SEP-IRA, mandatory minimum distributions start at age 70 1/2. Such distributions are taxed as ordinary income, as they were funded with pretax monies.
Roth IRA accounts are not subject to taxes when distributions are taken, since these accounts are funded with after-tax dollars. No taxes are due as long as the account has been in existence a minimum of five years. Unlike traditional IRAs, 401(k)s, 403(b)s and other employer-sponsored retirement plans, Roth IRAs don’t require mandatory distributions, which means you never have to take withdrawals. Treat your Roth IRA as an emergency fund or leave the proceeds to your beneficiaries if you don’t need the money.
If you make more than $25,000 in adjusted gross income when filing singly, or $32,000 if married filing jointly, expect to pay federal taxes on your Social Security income. For single filers with incomes between $25,001 and $34,000, 50 percent of their benefits are taxable, and that is also the case with married couples filing jointly with income ranging between $32,001 and $44,000. Above these amounts, 85 percent of Social Security income is taxable.
Annuities and Life Insurance Taxes
As noted, the IRS general rule for pensions also pertains to annuities, often purchased for a steady income flow in retirement. The portion of the annuity representing the principal isn’t taxable, but the rest is subject to tax. When annuities are purchased with pretax money, the income is taxed at ordinary income rates.
The beneficiary of a life insurance policy doesn’t pay taxes on the proceeds. If the policy owner wants to cash in the cash-value part of their own life insurance policy, these withdrawals are usually not taxed. Life insurance policies are designed in different ways, so contact your insurance agent if you’re considering cashing in the cash-value portion of your policy for retirement income. The agent can tell you whether or not cashing in the cash-value portion triggers tax.
Capital Gains Taxes on Investments
It’s likely you have investments outside of your retirement accounts that you may sell to help fund your retirement. The sale of stocks, bonds and mutual funds fall under the long-term capital gains rate if held over one year. Single filers with an adjusted gross income of less than $39,375 won’t owe any capital gains tax, and those married filing jointly won’t owe capital gains tax as long as their adjusted gross income is less than $78,750.
Single filers with an adjusted gross income between $39,375 and $434,549, owe 15 percent in capital gains tax, while a married couple filing jointly owes 15 percent in capital gains tax if their adjusted gross income is between $78,750 and $488,850. The capital gains rate climbs to 20 percent for taxpayers with incomes exceeding those amounts.
Stock and mutual fund dividends, a prime source of retirement income, are also taxed. A qualified dividend is taxed at the long-term capital gains rate, while a non-qualifying divide is taxed at ordinary income rates. Qualified dividends are those held more than 60 days between the time the company declares the dividend and the following 60 days.
A graduate of New York University, Jane Meggitt's work has appeared in dozens of publications, including PocketSense, Financial Advisor, Sapling, nj.com and The Nest.