The effect of paying taxes in retirement is one frequently disregarded component of retirement planning. When people do think about this, their two main questions are usually whether they will have to pay taxes in retirement and whether their income is taxable.
Yes, in general, both individuals and couples must pay taxes in retirement. That is the short answer. Retirement will mean that some taxes paid while working will no longer be due, but other taxes will still be payable.
Retirement is a time for relaxation and enjoyment, but it also brings new financial considerations. One of the most significant is understanding how taxes work on your pension income. This guide will provide a comprehensive overview of pension taxation, helping you navigate the complexities and optimize your financial planning.
Understanding Pension Taxation
When you receive pension payments, a portion of the amount is typically taxable. The taxable amount depends on several factors, including:
- Your contributions: If you contributed after-tax dollars to your pension plan, those contributions are not taxed when you receive them.
- Employer contributions: If your employer made contributions to your pension plan, those contributions may or may not be taxed depending on whether they were pre-tax or after-tax.
- Investment growth: Any earnings on your contributions and employer contributions are taxed as ordinary income when you receive them.
Calculating Your Taxable Pension Income
There are two methods for calculating your taxable pension income:
- General rule: This method involves subtracting your after-tax contributions from the total amount of your pension payments. The remaining amount is taxable.
- Simplified method: This method is generally easier to use and is available for individuals whose annuity starting date is after November 18, 1996. It involves multiplying your total pension payments by an exclusion ratio, which is determined by your age and the number of years you participated in the plan.
Tax Rates on Pension Income
The tax rate on your pension income depends on your overall taxable income. The current federal income tax brackets for single filers are:
- 10% on income up to $11,000
- 12% on income between $11,001 and $44,725
- 22% on income between $44,726 and $95,375
- 24% on income between $95,376 and $182,100
- 32% on income between $182,101 and $231,250
- 35% on income between $231,251 and $578,125
- 37% on income over $578,125
Additional Taxes on Early Distributions
If you receive pension payments before age 59½, you may be subject to an additional 10% tax on early distributions. This penalty does not apply to certain exceptions, such as distributions made as part of a series of substantially equal periodic payments, distributions made due to total and permanent disability, or distributions made to beneficiaries after the death of the plan participant.
Tax Withholding on Pension Payments
The taxable portion of your pension payments is generally subject to federal income tax withholding. You can choose to have no tax withheld or specify the amount of tax withheld. To do so, provide the payer with Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments.
Estimated Tax Payments
If the withheld tax on your pension payments is not enough, you may need to make estimated tax payments to avoid underpaying taxes during the tax year. For more information on estimated tax payments, refer to IRS Publication 505, Tax Withholding and Estimated Tax.
State and Local Taxes
In addition to federal income taxes, your pension income may also be subject to state and local income taxes. The specific rules vary by state and locality, so it’s important to check with your local tax authorities.
Special Considerations for Lump-Sum Distributions
If you receive a lump-sum distribution from your pension plan, special tax rules apply. For more information on the tax treatment of lump-sum distributions, refer to IRS Topic No. 412.
Understanding pension taxation is crucial for making informed financial decisions during retirement. By carefully considering the factors discussed in this guide, you can optimize your tax situation and maximize your retirement income.
Additional Resources
- IRS Topic No. 410, Pensions and Annuities
- IRS Publication 575, Pension and Annuity Income
- IRS Publication 505, Tax Withholding and Estimated Tax
- FINRA Investor Insights: Taxation of Retirement Income
Disclaimer:
This guide is intended for informational purposes only and should not be considered tax advice. It is essential to consult with a qualified tax professional for personalized advice regarding your specific situation.
Other taxes in retirement
When you retire, you will also be responsible for paying sales taxes on top of your federal and state income taxes. When you buy goods and certain services, such as meals at restaurants and electronics, you must pay sales taxes. Your shopping habits and the sales tax rates in your city and state will determine how much you ultimately pay in sales taxes.
After you retire, if you own your home, you will still be required to pay property taxes. Because property taxes are based on the value of the home, which can increase over time, this is one of the largest tax burdens for many retirees. However, you might be able to claim property taxes as an itemized deduction if you itemize deductions on your income tax return, which could reduce your tax liability. It is significant to remember that, if you itemize your deductions, state income, sales, and property taxes are currently capped at $10,000 in total. 5.
Finally, depending on your income, you might have to pay the Net Investment Income Tax (NIIT) after you retire. This is a 3.8% Medicare surtax that applies to net investment income above certain thresholds. The NIIT generally applies to interest, dividends, and capital gains and losses, as well as income from passive sources. If your modified adjusted gross income is above $200,000 for Individual filers (or $250,000 if you’re married and file your income taxes jointly) for the 2023 tax year, you will be subject to the NIIT on all or a portion of your net investment income.6
Are Social Security benefits taxable?
Approximately 56% of Social Security recipients must pay income tax on their Social Security benefits.7
Your income and filing status will determine whether your Social Security benefits are taxable.
Take half of your annual Social Security benefits and add it to your other income to find out if your benefits are taxable. Pensions, wages, interest (including tax-exempt interest), dividends, capital gains, etc. are examples of other sources of income. This sum is also referred to as your “base amount”.
- For individuals filing alone, if your base amount exceeds $25,000, you may be subject to taxes on up to 80% of your Social Security benefits.
- When married individuals file jointly, if their base amount exceeds $32,000, they may be subject to taxes on up to 50% of their Social Security benefits.
Up to 85% of your benefit may be taxable for single filers with a base amount greater than $34,000 and if you’re married filing jointly if your base amount is greater than $44,000 a year . No more than 85% of Social Security benefits is ever taxable, regardless of the amount of your other modified adjusted gross income under current regulations. taxable, regardless of your other income under current regulations.8
A number of states, including Colorado, Connecticut, Kansas, Minnesota, Montana, New Mexico, Rhode Island, Utah, and Vermont, additionally impose state income taxes on Social Security benefits. The 2024 tax year marks the end of Social Security benefit taxation in the states of Missouri and Nebraska, and the 2024 tax year marks the start of a three-year phase-out of Social Security benefit taxation in the state of West Virginia.
While Social Security benefits may be taxable in such states, some do provide for a lower limit on how much of those benefits may be taxed. Colorado, for instance, provides a subtraction limit for most types of retirement income sources (including Social Security benefits) up to $24,000 per individual over age 65.9
Every tax year, you should check with your state of residency to see if any applicable exclusions apply.
Read more: Social security payments are going up
Do you have to pay income tax on retirement pension?
FAQ
What taxes are paid on a pension?
How much federal tax is taken out of pension check?
At what age do you stop paying taxes on your pension?
What is the federal tax rate on retirement income?
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Tax rate
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Single filers
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Head of household
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12%
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$11,000 to $44,725
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$15,700 to $59,850
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22%
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$44,725 to $95,375
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$59,850 to $95,350
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24%
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$95,375 to $182,100
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$95,350 to $182,100
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32%
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$182,100 to $231,250
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$182,100 to $231,250
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Do you pay income tax on a pension?
Pensions are usually funded with pre-tax income, so you will pay income tax on all pension payments (unless you contributed after-tax to your pension) upon withdrawal. There are some states that do not tax pensions. So, you will not pay state income tax upon withdrawal of the funds. Does your state have a retirement exclusion?
Do you pay income tax on a retirement account?
Federal income tax is determined by your tax bracket. If you live in a state with income tax, you may pay that, too. State income tax rates vary, and some states don’t have income taxes. Each type of retirement account has rules about when you can take a distribution. If you take a distribution too soon, you could face penalties.
How much tax should I withhold from my pension?
If you are newly retired, it can be difficult to figure out how much in taxes to withhold from your pension, because your tax rate depends on your household sources of income and deductions. When you add up all your sources of income and subtract your deductions, you get your taxable income, which determines your tax bracket.
How much tax do I owe on my pension?
You fill out a pretend tax return and calculate that you will owe $5,000 in taxes. That is a 10% rate. You can have 10% in federal taxes withheld directly from your pension and IRA distribution so that you would receive a net $18,000 from your pension and $27,000 from your IRA.