Federal Taxes on Pension Benefits
Retirement planning can be difficult enough with the uncertainties of the stock market directly affecting your nest egg. Trying to project retirement income without understanding how the IRS handles your pension income is a recipe for poor retirement planning. The Internal Revenue Service assesses federal taxes on some pensions, assesses partial taxes on others and allows you to collect tax-free on other types of pensions. In most cases, you should plan on the tax man taking his share of your pension income.
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Taxable Pensions
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If you didn't contribute directly from your paycheck into the pension fund each month or if you made pretax contributions to the pension plan, expect to pay taxes on all pension income. The IRS taxes pensions similarly to any other wages, assessing income tax at the rate appropriate for your tax bracket. As a general rule of thumb, if you avoided paying income taxes on the earnings that provide the basis for your pension account, expect to pay taxes when you access those funds.
Partially Taxed Pensions
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The IRS only taxes income once: If you deferred taxation with pretax contributions, you'll owe taxes on pensions. If contributions to your pension plan were made after income taxes were assessed, such as with voluntary additional contributions to a retirement fund, you'll only be taxed on the portion of your pension generated from the pretax contributions. Use the Simplified Method Worksheet provided with Form 1040 to determine the portion of your pension that's taxable if you began receiving benefits after Nov. 18 1996.
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Tax Free Pensions
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In some cases, beneficiaries who receive a pension from the Social Security Administration or through a similar railroad pension, you may not be liable for taxes. Those benefits are only taxable when you receive income from other sources such as a secondary pension or part-time job and your modified earnings exceed the base amount for your filing status. In the case that your pension consists entirely of post-tax contributions, you won't owe income taxes on your pension.
Pension Withholding
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To avoid a large tax bill at the end of the year, submit a W-4P to your pension fund manager. This worksheet is similar to a W-4 workers submit to their employer and allows your pension manager to withhold a portion of each pension payment similar to the withholding of payroll taxes. Although you'll receive less each pension payment, you'll address tax issues before filing your year-end taxes.
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