Your employer's retirement plan is "qualified" if it meets the standards in section 401(a) of the tax code. Pension or defined-benefit plans are one type of qualified plan; defined-contribution plans, such as a 401(k) plans, are another. Distributions are withdrawals from the plan. Most of your distributions from a qualified retirement plan are taxable.
Defined Contribution Plans
With a defined-contribution plan, you put a set amount into the plan each paycheck, possibly boosted by employer contributions. Your contributions are tax-free, but your distributions aren't. With a 401(k), for example, withdrawals you make from the account are all taxable income. If you start withdrawing before age 59 1/2, you pay a 10 percent tax penalty on top of the regular tax. Other defined-contribution plans operate on the same general principles.
If you leave your job, for example, you have the option to transfer the money to a new employer's 401(k) or place it in an IRA. There's no tax on the withdrawal, either way. Otherwise, your employment plan withdrawals are going to add to your tax bill. In hardship cases -- for example, suppose you need to tap the plan to stop foreclosure -- the IRS allows you to withdraw early without paying a penalty, but you still pay tax.
With a defined benefit plan, such as a traditional pension, your employer guarantees you a specified level of benefits in retirement. Such a plan often gives you the option to receive benefits every month as long as you're alive. Many plans offer the option to take a single lump sum benefit when you retire instead. The extent to which the retirement benefits you receive are taxable depends on who funded the plan, and with what money.
If your employer funds the pension without any help from you, everything you get from the plan is taxable income. If you contributed some of your pay to the plan with after-tax dollars, some of your distributions are tax-free. Say you receive monthly payments from a pension to which you contributed $30,000 over the years. If you expect to receive 300 monthly payments, $100 a month is free of tax. IRS Publication 575 shows how to figure the nontaxable amount.
A graduate of Oberlin College, Fraser Sherman began writing in 1981. Since then he's researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history. Sherman has worked for more than a decade as a newspaper reporter, and his magazine articles have been published in "Newsweek," "Air & Space," "Backpacker" and "Boys' Life." Sherman is also the author of three film reference books, with a fourth currently under way.