Pensions aren’t as common as they once were, with many retirees receiving income from 401(k)s and similar employer-sponsored retirement plans and IRAs instead. For those seniors who do receive pensions, most can expect some form of pension tax. Some states tax pensions, which is one reason many seniors move to a more tax-friendly clime after retirement.
Since your pension was likely funded with pre-tax dollars, you can expect to pay some kind of income tax on your pension income.
IRS General Rule for Pensions and Annuities
The IRS warns, “If you receive retirement benefits in the form of pension or annuity payments from a qualified employer retirement plan, all or some portion of the amounts you receive may be taxable.” Pensions are fully taxable at ordinary income rates if you did not contribute funds to the pension, or if your employer did not withhold contributions from your salary. Your pension is also fully taxable if you received all of your contributions tax-free in prior years, according to the IRS. Most pensions are funded with pre-tax dollars.
Pension payments are partly taxable if contributions to the pension were made with after-tax dollars. You are not responsible for paying taxes on the portion of the payment representing a return of your after-tax payment. Your after-tax payment is considered your investment in the pension contract, but this also includes taxable amounts to you contributed by your employer.
If you made contributions to your pension with pre-tax dollars, similar to a 401(k), you are deferring tax payment, not eliminating it. Once you retire, you must pay taxes on the income.
Effects of Early Retirement
As with 401(k)s and traditional IRAs, you will face a 10 percent tax on distributions if you begin receiving pension payments before reaching the age of 59.5. However, the IRS makes an exception to this tax if the person must take distributions because they are totally and permanently disabled, or if the distributions are made as “part of a series of substantially equal periodic payments” once the person leaves their job. You will also not face the penalty if the distributions were made after separation from service in the year or after the year in which you turned 55.
States and Pension Taxes
Most states will tax your pension income. However, there are 14 states that do not tax pensions, and you may want to consider relocating to them after retirement if your pension is your main source of income. The states are:
- New Hampshire
- South Dakota
Several of these states do not have a state income tax, but before putting your home on the market and moving to a pension tax-free state, you need to perform additional research. While most of these states do not tax Social Security benefits, some of them do tax 401(k) and IRA distributions. That’s why it’s important to do your homework and figure out where the bulk of your income from retirement will come from, and make any relocation decisions accordingly.
Taxes and Other Retirement Accounts
It’s likely you or your spouse have other types of retirement income besides a pension. If you have an employer-sponsored retirement plan or a traditional or SEP-IRA, you must start taking distributions by the time you turn 70.5. When you begin taking distributions from these retirement accounts, you are taxed at your ordinary income rate. These accounts were funded with pre-tax dollars, so taxes were deferred.
If you have Roth IRA accounts, that’s a different story. These accounts are funded with post-tax dollars, so when you begin taking distributions – as long as the account was established at least five years prior – you do not owe any tax on your withdrawals.
There is no required mandatory distribution with Roth IRAs, so if you don’t need the money, you don’t have to make withdrawals and can use your Roth IRA as an emergency fund or leave it to your heirs. One caveat: If you start taking Roth IRA distributions prior to age 59.5, you will owe a 10 percent penalty on your earnings, but not your principal.
Taxes and Social Security Income
Social Security isn’t taxed if your retirement income is relatively low, but above $25,000 in adjusted gross income for a single filer and $32,000 for married couples filing jointly, expect that the taxman cometh. Single filers with income between $25,001 and $34,000 will find half of their Social Security benefits subject to tax, and the same holds true for married couples filing jointly with an income between $32,001 and $44,000. Once your income rises above these levels, expect up to 85 percent of your Social Security income to be subject to taxation.
Annuity Income and Life Insurance
Many people purchase annuities for guaranteed income during retirement. You do not have to pay taxes on the portion of your annuity representing your principal, but the rest is taxable. Before purchasing an annuity, ask the insurance agent just how much is taxable. However, if you purchased an annuity with pre-tax money, the entire amount of your payment is taxable. Keep in mind that annuities are taxed as ordinary income, not as capital gains.
Life insurance proceeds are not taxable to the beneficiary after the policy owner’s death. If your life insurance policy has a cash-value portion and you decide to cash it in, such a withdrawal is generally tax-free. However, this requires the proper structuring of the policy. Your insurance agent can give you more information about your policy’s structure and whether cashing it in will result in a taxable event.
Taxes on Other Investment Vehicles
Most retirees have investment vehicles outside of retirement accounts. If you decide to sell your stocks, mutual funds or bonds to fund part of your retirement, the proceeds are taxed at long-term capital gains rate if you’ve held these investments for more than one year. The good news is that if you are a single filer with an adjusted gross income of less than $39,375, you will owe zero capital gains tax when you sell. If married filing jointly, you will not owe capital gains tax if your adjusted gross income is under $78,750.
If a single filer’s adjusted gross income is between $39,375 and $434,549, they will owe 15 percent in capital gains tax. A married couple filing jointly will owe 15 percent in capital gains tax if their adjusted gross income is between $78,750 and $488,850. Above those amounts, the capital gains tax rate is 20 percent.
You may also receive dividends from your stocks or mutual funds. Qualified dividends are taxed as long-term capital gains, while non-qualified dividends are subject to taxation at ordinary income rates. For a dividend to be considered qualifying, you must hold it for more than 60 days within the time period starting 60 days before the company declares a dividend and 60 days afterward.
Taxes on Retirement Income Calculator
The easiest way to determine how much you can expect to pay in taxes in a given state is by using a taxes on retirement income calculator, available online. Visit a site offering information on how every state taxes retirement income. You will also receive additional critical information, such as a state’s cost of living and property taxes.
For example, New Jersey’s state income taxes on pensions under $65,000 are relatively low, but its property taxes are among the nation’s highest.
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.