Posted by Abundant Wealth Planning LLC

How Certain Types of Pension Income Are Taxed

How Certain Types of Pension Income Are Taxed

When planning your retirement, it's fun to contemplate all the trips, the golf courses, and the restaurant meals that lie ahead. You deserve it! However, many retirees ignore the cumulative impact of federal and state income taxes on withdrawals from their pensions.

Most retirement income forms, including Social Security benefits and traditional 401 (k) and IRA withdrawals, are taxed by Uncle Sam. What if you don't live in one of the nine countries that do not have a traditional income tax? You can expect your home state to tax your pension as well. (Retirement taxes vary by state, so be sure to check out your state's plans to see the impact of the general tax on your pensions). So do yourself a favor and acquaint yourself with different types of pension income that are taxed.

Traditional IRAs and 401(k)s

Savers love these deferred retirement accounts. Contributions to plans generally reduce taxable income, which saves money in current year tax accounts. Their savings, dividends, and investment income in accounts continue to grow with the tax-deferred.

They tend to forget that they will pay taxes in the future when they retire and start making withdrawals and that those taxes will be applied to their income and contributions before taxes or deductions. At some point, you will need to withdraw money from your accounts. The Required Minimum Distributions (RMD) takes effect at 72 for traditional account holders and 401(k) (70.5 if born before July 1, 1949). People who work after 72 years old can usually defer treatment with 401(k) RMD until retirement. (The CARES Act, passed in March 2020, exempted RMD from IRAs in 2020; defined contribution work plans such as 401(k)s; 403(b) and 457(b) government employer funding plans; and Federal Savings plan.)

The tax rate you pay for your traditional IRA and 401(k) withdrawals would be your normal tax rate.

Roth IRA

Roth IRAs have a great long-term tax advantage: contributions to Roth accounts are not deductible, but withdrawals are tax-free.

Two important caveats: You must have kept your account for at least five years before you can withdraw it for free. And, as much as you can withdraw the amount you contributed at any time without taxes, you need to be at least 59.5 to withdraw your earnings without incurring a 10% early withdrawal penalty.

Social Security

In the past, Social Security benefits were tax-free for everyone, but that story ended in 1983. For many Social Security recipients, benefits are not yet taxed. But others, who depend on "middle income," are not so lucky and may have to pay up to 85% federal income tax. To determine your middle income, take your adjusted gross income, add half of your Social Security benefits, and add all of your non-taxable interest.

If your average income is less than $25,000 ($32,000 for couples filing jointly), your Social Security benefits are tax-exempt.

If your interim income is between $25,000 and $34,000 ($32,000 and $44,000 for joint owners), up to 50% of your benefits are taxable.

If your middle income is over $34,000 ($44,000 for regular taxpayers), up to 85% of your benefits are taxable.


Most pensions are funded from pre-tax income, which means that the full amount of your pension income would be taxed when you receive the funds. Private and government pension payments are generally taxed at the normal return rate, provided you have not made after-tax contributions to the plan.


Chances are, some (or all) of the income you receive from any income you hold is taxable.

If you have purchased an annuity that provides pension income, the portion of the payment representing your principal is exempt from tax; the rest is taxable. For instance, if you purchased an annuity for $250,000 and it was worth $320,000 over a 10-year period, you would only pay tax on the $70,000 of accrued interest. The insurer who sold you the annuity must tell you what is taxable.

Different rules apply if you bought an annuity with pre-tax funds (like a traditional IRA). In this case, 100% of the payment will be taxed as normal income. Also, keep in mind that you will have to pay the taxes owed on the annuity at the normal income tax rate, not the prime capital gain rate.



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