Understanding tax withholding on pension payments

If you're counting on pension payments for retirement, understanding how it and other retirement income sources are taxed can make a big difference in your post-career budget. As you plan for your retirement lifestyle, including supporting yourself, your family and causes that matter to you, you'll want to know what pension taxes to expect.

Pensions are usually funded with pre-tax contributions, so federal income taxes will be due in most cases. State taxes on pensions have more nuances to determine if taxes will be due.

Let’s explore the ins and outs of how pension taxes work on both a federal and state level.

In most cases, pension payments are subject to federal income tax withholding set at a default of 10%, though you can adjust your rate or opt to make periodic payments instead.

Your payments are taxable if you and the employer made contributions with pre-tax dollars—that is, no income taxes were paid on them before they went into the pension fund. Your receipt of the pension payment is what triggers the taxes due on that money.

However, you won't have taxes withheld or owe them on your pension payment if your pension was funded with after-tax dollars. In that case, much like a Roth account, you already would have paid the income tax due on that money before it went into the pension fund. This is pretty unusual, so it's best to check with your pension administrator to be absolutely sure.

In either case—whether your pension was funded with pre- or after-tax dollars—you can face tax penalties for taking money out of your pension before age 59½. There are some exceptions, such as penalty-free withdrawals if you leave a job during the calendar year you turn 55 or later. The best bet if you need to withdraw from a pension early is to check with the plan administrator or your tax professional before you take money out so you know what it might cost you.

It depends. Certain states don't tax retirement accounts at the state level. It can be complex because the tax determination may depend on where you originally earned your income versus where you live now. It's worth checking with a tax professional, but here are some basics to help you get started in evaluating your particular situation.

• Some states don't have income tax. Those states are Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming. New Hampshire also has a modified income tax that only applies to dividends and interest. (Keep in mind that while not paying income tax may sound great, these states may charge more in property and sales taxes, which also factor into your retirement expenses.)

• Several states provide an income tax deduction for your pension. These can be substantial and may mean you don't pay tax on your pension benefit at all. These states include Alabama, Hawaii, Illinois, Iowa, Mississippi and Pennsylvania.

• The remaining states may tax pension benefits. Note that there may be deductions or exemptions if your total income is lower than a certain threshold. Some states also have started offering an exemption for the first few thousand dollars of pension benefits, which may be useful to keep your overall tax burden lower.

Pension income is subject to ordinary income taxes at the federal level. This means that you'll trigger ordinary federal income tax whether you choose pension payments or a lump sum. However, lump sum distributions may push you into a higher tax bracket for that year, meaning that your effective tax rate is higher than if you took a smaller payment for multiple years.

One of the times someone might choose this higher tax burden anyway is if they want greater control over how their money can be invested or managed in retirement, such as rolling over to an IRA or purchasing an IRA annuity. A financial advisor can help you work out whether the benefits you're considering with a lump sum distribution would be undercut by higher taxes.

Thrivent financial advisors are experienced in the details, like tax withholding on pension payments, and the big-picture goals, like making your retirement years secure so you can live generously and without fear. Managing the tax details well is just one part of the puzzle, and having a helpful guide can make sure you find a great financial path for you.

Want more info about taxes in retirement? See our comprehensive guide