Does a Pension Distribution Count as Income?
Retirement distributions from your employer’s pension program generally are included in your taxable income. Pension distributions may be fully taxable or only partially taxable, depending on how the employer set up the pension plan. Benefits from Railroad Retirement or Social Security don't count as pension distributions and are separately taxed.
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Pension Basis
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Your pension benefits are fully taxable as ordinary income if you did not contribute anything toward your pension, your employer did not withhold contributions from your salary or you withdrew all your contributions prior to retirement. Your benefit would be partially taxable if the distribution included money you contributed. Your contributions are considered your “basis” or after-tax investment in the program. Because your basis contributions were taxed before you put them into the program, any part of your pension distribution comprised of your contributions isn’t taxable. The rest is subject to tax.
Figuring Tax
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When you start receiving periodic pension distributions from a program where you made after-tax contributions, you must determine what portion of your benefit payments represent a return of your nontaxable contributions. Under IRS rules, you recover your after-tax pension contributions through periodic pension payments over a span of about 25 years. The IRS provides a complex 11-step, declining-balance formula for figuring the portion of each year’s pension distribution that represents your nontaxable contributions. If you take your entire pension benefit in a single lump-sum distribution and don’t roll it over into another tax-deferred retirement plan, you subtract your after-tax contributions from the total and pay income taxes on the employer contributions and all earnings.
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Tax Withholding
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You have a choice of whether you want income taxes withheld from your taxable pension distributions and how much to withhold by giving your pension fiduciary a Form W-4P, Withholding Certificate for Pension and Annuity Payments. If you don’t waive withholding or specify a withholding amount, the payer will withhold taxes as though you were married with three dependents. If your pension payer doesn’t have your correct Social Security number, it must withhold taxes as though you were single with no dependents. If you don’t have taxes withheld, you must make quarterly estimated tax payments on your taxable pension distributions.
Early Distributions
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If you receive pension distributions early, before age 59½, you usually must pay a 10 percent penalty tax in addition to the income tax due on the taxable portion of your distributions. But the penalty doesn’t apply if your early distribution was part of an annuity-type payment plan providing equal periodic payments starting when you separated from your employer’s service. The penalty tax on early pension distributions also is waived if you become permanently disabled, or are 55 or older and start taking early distributions after you left your employer’s service.
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References
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