Posted by James Financial Services Inc

How Capital Gains Tax Works on Pension

How Capital Gains Tax Works on Pension

Pension Funds

Pension fund is a type of plan in which employers, workers, or both decide to put aside funds to make life easier during retirement. The pension company invests the money in a series of financial securities for many years. Over the years, the money generates interest, and the workers get them as income when retired.

Pension Funds and Taxes

Over time, pension funds generate assets that serve as a form of benefit to the employer during retirement. Usually, the employee will either accept a lump-sum payment or monthly income from the pension firm.

Capital gains tax applies to profit from the sale of some form of assets like bonds, mutual funds, and exchange-traded funds. There are two forms of capital gains tax: short term gain tax and long term capital gains tax.

Short term capital gains tax concerns accrued profits and revenues from securities bought and sold in a year. On the other hand, long-term capital gains are profits and revenues from securities purchased and sold in more than a year.

These gains are not taxed at the same rate. For assets like stocks, funds, and bonds, the long term gain could be 0% or 15% or 20%. The income level of the individual or entity is the deciding factor. The short term capital tax gains are similar to the individual's ordinary income tax rate.

Since most pension funds are invested in these forms of assets, it is customary to expect to pay such taxes. Pension funds, however, are usually not directed to capital gains. As a result, the asset will grow uniquely without charges over the years.

Benefits Pension Funds get From Not Paying Capital Gains Taxes. 

Pension funds typically are not subjected to capital gain taxes. As a result, the assets in the funds can grow faster. Shall we assume we have a pension fund with an initial balance of $20 million. This fund grew every year at 10% for five years without paying any capital gains taxes. At the year-end, the whole portfolio is rebalanced, leading to the sale and replacement of all investments. By the end of the five years, the funds would have increased to $30.2 million without capital gains taxes throughout the year. 

Let us also consider a second case in which there will be capital gain taxes through the year. A fund with an initial balance of $10 million with a growth rate of 10% per year will be worth $15.04 million after five years. This figure is right, provided the funds were rebalanced after each year with a capital gain tax of 15%. The total amount paid in capital gains taxes is $889,000.

Since the pension funds in the first example did not have to pay capital gains taxes, the money was saved. This money was included in the pension funds, which kept growing with it, resulting in more additions to the pension balance.

Taxes on Employee Distributions

Considering the pension funds itself, there is no need for capital gains taxes. The tax rate for the employee’s distribution will be the income tax rate. For an employee that uses the pension funds distribution for their investment, there will be capital gains taxes in the year of the gain.

Since the pension funds do not involve tax before the distribution, the employee will get more significant benefit.

Special Considerations

Although there are no capital gains for pension funds, the firms in charge of the pension funds must pay corporate taxes. The implication of this is that it will affect the amount the company eventually sends to the employees' pension funds. This also affects the investor’s balance. 


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