All About Taxes on Pensions

If you have a pension, consider yourself fortunate. Traditional defined benefit plans, such as pensions, have become increasingly rare, often replaced by defined contribution plans like 401(k)s. However, accessing your pension income in retirement isn’t entirely tax-free – some or all of it may be subject to taxation. Working with a financial advisor can help you develop a tax-efficient strategy to maximize your retirement income. Here’s what you need to know.

Pensions – The Basics

Your pension plan outlines a specific retirement age when you can begin receiving benefits, typically set at 65. However, similar to Social Security, you may have the option to start collecting reduced benefits at an earlier age. To understand how your pension income changes depending on when you claim, you can request a benefits schedule from your plan administrator.

When you retire, you’ll generally have two options for receiving your pension payout: a lump sum or monthly annuitized payments that last for life. Choosing a lump sum gives you immediate control over your funds, protecting you from potential company insolvency or pension defaults. You can invest the money as you see fit and even pass any remaining funds on to your heirs.

However, taking a lump sum comes with the risk of depleting your savings too quickly, leaving you financially vulnerable in later years. Opting for monthly payments provides a steady, guaranteed income for life, helping you manage spending. But it also means less flexibility – your money remains tied to the company’s pension system, and you won’t have control over investment decisions or the ability to leave the full amount to your heirs.

Taxes on Pensions – How It Works

Two women talking and laughing, enjoying their retirement.

Regardless of whether you opt to take your pension income in a lump sum or in monthly payments, it’s good to have a tax strategy. Unless you contributed to your pension, the entirety of your pension income will be taxable at your regular income tax rate. In other words, if your pension income all comes from money your employer contributed, with no additional contributions on your part, it’s all fully taxable.

How Much of Your Pension Is Taxable?

According to the IRS, your pension income is fully taxable if any of the following applies to you:

You didn’t contribute anything for your pension or annuity
Your employer didn’t withhold contributions from your salary, or
You received all of your contributions tax-free in prior years

If you contributed after-tax dollars to your pension, your pension will be partially taxable. You won’t owe taxes on the amount you contributed in after-tax dollars.

How Do Pension Distributions Work?

If you take distributions from your pension before age 59 1/2, you may owe a 10% penalty on top of your regular income taxes. The only way you can get out of this early withdrawal penalty is:

If the distributions are taken because you have become permanently disabled
If the distributions are made on or after the death of the pension plan participant (in other words, you’re a survivor claiming the pension of the deceased)
If the distributions are made after you separate from service and before you turn 55
If the distributions are made after you separate from service as part of a series of substantially equal periodic payments

If you’re considering making an early withdrawal and you’re not sure whether you would trigger the 10% penalty it’s a good idea to check with the company that administers the plan before you take the plunge.

If you opt for monthly pension payments, you won’t be able to lessen your tax burden by easing up on withdrawals like you could with a 401(k) or an IRA. Your monthly pension payments might amount to more money than you really need and all of it will be taxable. If you had the same amount of money in an IRA or 401(k) you could delay withdrawals, opt for a smaller monthly income and enjoy more tax-free growth on your retirement fund. Still, most people would rather have a pension from their employer’s money than a 401(k) from their own.

Requesting Tax Withholding from Your Pension Income

You can ask the company that administers your pension to withhold income taxes from your pension if you’re afraid you’ll get slammed with a big bill at tax time. Withholding, which you can request on IRS Form W-4P, will let you pay your federal income taxes as you go, putting that money aside throughout the year rather than having to come up with it all in April. It’s comparable to the regular W-4 you give your employer for tax withholding purposes. If you don’t think enough money is being withheld from your pension, you can also make estimated tax payments.

Bottom Line

A pension is a valuable source of retirement income and something many Americans wish they had. When you’re approaching your retirement age, it’s a good idea to work out a financial plan that will cover how much you’ll spend and that accounts for your tax bill. In the first year you start claiming pension funds, it’s wise to set aside plenty of money for your taxes so you don’t come up short at filing time.

Tips for Filing Your Taxes

A financial advisor can help optimize your tax strategy for your financial goals. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors who can help you achieve your financial goals, get started now.
When the tax code changes, it’s a good idea to use a good tax filing service. We did our annual roundup of the best tax filing software so that you can get through this tax season as painlessly as possible.
If you want to see whether you’ll get a tax refund or have to pay a tax bill, SmartAsset’s tax return calculator can help you plan ahead.