Reporting Pension or Annuity Income on Taxes

Pension plans allow employers and employees to contribute towards the employees’ future retirement. There are many types of pension or retirement plans available to taxpayers, with many similarities and differences among the plans. The one thing that is the same across the board is that there is a 10% additional tax on most plan distributions prior to age 59½, or retirement, whichever comes first. 

What are the different types of pension plans?

• Contributory plans allow employees to fully or partially fund their own retirement account.
• A deferred compensation plan is a contributory plan. The contribution is not subject to federal income taxes until the taxpayer withdraws the funds from the plan. Distributions from this type of retirement plan are taxable when received. A 401(k) plan is one of the most common types of deferred compensation plans.
• The common 401(k) or 403(b) plan is another form of contributory retirement plan. Employers can set up additional rules in 401(k) and 403(b) deferred compensation plans to allow a taxpayer to treat all of or part of elective deferrals as after-tax Roth contributions. You are not allowed to deduct contributions to a 401(k) or 403(b) plan that are treated as Roth contributions. These contributions are treated as regular taxable income on your Form W-2. The distributions from these accounts are tax-free under the same provisions as a Roth IRA.
• Non-contributory plans are generally fully funded by the employer and do not allow any contributions by the employee. The employer and employee enter into a contract requiring a specified number of years of employment in exchange for a specific amount of monthly retirement once the employee fulfills their obligation. All of the distributions from this type of retirement plan are taxable when received.
• An annuity is a pension plan that requires employees to pay for a future retirement benefit. An example of this type of plan is a Civil Service pension. The payment is deducted from an employee's paycheck every payday after taxes are deducted. A portion of each distribution is not taxed.

Will my pension be taxed as income? 

When you begin receiving periodic payments or distributions from your pension plan, you must determine whether the full amount you receive is taxable to you. If you have no cost in your pension plan, your payments are fully taxable. Generally, you have no cost in your plan if:

• You did not pay anything or are not considered to have paid anything for your pension
• Your employer did not withhold tax-deferred contributions from your salary
• You received all of your contributions tax free in prior years
• You chose to make your account a Roth account making the contributions taxable and all distributions tax-free.

However, if you have a cost to recover from your pension plan, you can exclude part of each distribution payment from income as a recovery of your cost. Generally, you can recover the cost of your pension tax free over the period you are to receive the payments. This tax-free part of the payment is determined when your payments start and remains the same each year, even if the payment amount changes. The amount of each payment that is more than the tax-free part is taxable.

Generally, your plan administrator will have calculated the tax-free portion of your annual distribution and reported it correctly on Form 1099-R. If you must calculate the tax-free part of the payment, you can usually use the simplified method. You must use the general rule if your payments are from a nonqualified plan.

You determine which method to use when you begin receiving your payments, and you continue using the same method each year that you recover part of your cost.

Will early distributions affect the way I report my pension income?

To discourage the use of pension funds for purposes other than normal retirement, the law imposes additional taxes on early distributions of those funds. Generally, if you receive distributions from your pension plan before reaching age 59 ½, you will be subject to a 10% additional tax on the part you must include in your gross income unless you meet one of the exceptions. Some exceptions to the additional tax are:

• Distributions made as part of a series of substantially equal periodic payments for your life beginning after separation from service
• Distributions made because you are permanently and totally disabled
• Distributions because you are age 55 or older and retired or separated from service
• Distributions required by the courts in a divorce settlement
• Distributions used to pay deductible medical expenses (expenses greater than 7.5% of adjusted gross income) whether or not you itemize your deductions
• Distributions from an ESOP for dividends on employer securities held by the plan
• Distributions due to an IRS levy on the plan
• Distributions to a beneficiary of a deceased taxpayer

How will I receive my pension?

Many pension plans allow the recipient to receive all the funds in a lump sum. You can also roll all or part of your pension, or retirement plan, into an IRA. 

Distributions from pension and retirement plans are usually required either when the recipient retires, or when they turn 72 years old, whichever comes later. The amount of your distributions are based on the value of the pension plan, along with your life expectancy when you start withdrawals. 

Can I combine my pension plan with my IRA?

By rolling your pension into an IRA, you would gain control over your own investments, as well as how much money you want to withdraw and when you’d like to do it. Traditional IRAs require distributions to start at age 72. 

You can transfer funds from your qualified retirement plan to an IRA before the due date of your tax return and pay no income tax. You must roll over the funds to another qualified plan within 60 days after receiving the distribution. The opportunity to roll over pension plan funds into alternate plans or an IRA is an ideal way for an employee who leaves their job to avoid the tax liability assessed when the plan is terminated and a distribution check is issued. The rollover is a tax benefit that eliminates the payment of taxes on a distribution made for any reason other than a regular retirement distribution. Retirement plan administrators/trustees are required by law to permit a transfer of funds from their retirement plan directly to another qualified plan. This is known as a "trustee-to-trustee" transfer. The law favors the "trustee-to-trustee" transfer and discourages handing a distribution check to the plan beneficiary by requiring plans to withhold 20% of the distribution before a check is issued. Therefore, a check will be issued for only 80% of the total amount distributed. This can be a "tax trap" for those who want to roll over a distribution but do not have the funds available equal to the amount withheld. The 20% withheld needs to be replaced from other sources and included as part of the rollover within the 60-day period or the 20% will be considered to have been distributed and subject to taxes. The IRS may waive the 60-day requirement for rollovers from pensions if you have suffered from a casualty, disaster, or other event beyond your reasonable control that prevents you from meeting the 60-day rule.