Key takeaways
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.
Are pensions taxable?
Let’s explore the ins and outs of how pension taxes work on both a federal and state level.
What are the federal taxes on pensions?
In most cases, pension payments are subject to
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
Is there a state tax on pensions?
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.
Is taxation different for pension payments vs. a lump sum?
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
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
