Pension payments play a vital role in providing income for many retirees, but there are typically tax consequences when you receive pension income. How much of your pension check is taxable depends on whether you made contributions toward your pension and the way your employer set up the pension plan.
When your entire pension is taxable
In some situations, every penny of your pension check will be taxable for federal purposes. If you did not contribute anything toward your pension, then any payments you receive will be fully taxable. Similarly, pensions are fully taxable if your employer did not withhold any contributions toward your pension from your salary. Finally, if you received all of your contributions in previous years, then any future payments will be fully taxable.
The rationale behind fully taxing a pension is that in the situations above, you either made no investment in the contract or have already gotten your investment back. What's left is essentially free money to you, and so the IRS doesn't have a reason not to tax it.
When only part of your pension is taxable
By contrast, a portion of your pension will be tax-free if you contributed after-tax dollars toward your pension. You'll get credit for the contributions you made into the pension plan, and when you receive that money back, it won't be taxed to you. Earnings on that money, however, will be taxed, as well as any additional amounts your employer pays.
Calculating the taxable portion usually involves using what's known as the Simplified Method. To do so, you'll fill out a worksheet from the IRS to come up with exact numbers. The gist of the Simplified Method, though, is to prorate your contributions toward the pension plan over your expected lifetime, allowing you to get tax-free treatment for a portion of your cost each year. You get to carry forward any unused contribution credits in future years.
The key for planning for your retirement if you expect to receive a pension is to remember that much if not all of the money you get in a monthly pension check will be included in your taxable income. The tax that you have to pay as a result is an expense that you might not have anticipated, and it can dramatically reduce the value of your pension income in certain situations.
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