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Pensions and Taxes

You would think that reporting income for tax purposes would be simpler during retirement, but the rules for reporting income vary depending on the type of pension you have. This article provides a brief overview of the various ways that pensions are taxed and how you can estimate how much tax you owe.

IRS Form 1099-R

You should receive an IRS Form 1099-R whenever you receive a distribution of $10 or more from a pension plan, annuity, retirement or profit-sharing plan, IRA, or insurance contract. You may receive multiple Form 1099-Rs if you received distributions from more than one pension or retirement plan, you moved to a different state, or for various other reasons.

Your 1099-R will show the taxable amount of your income from these distributions. If your employer made all of the contributions to your pension fund while you were working, then any distributions you receive when you retire are fully taxable. Likewise, if you made pretax contributions to your retirement fund, the distributions will also be taxable since you didn’t pay taxes on the money when you earned it.

But not all distributions reported on your 1099-R are taxable. If you made after-tax distributions to a pension plan or retirement plan, those distributions are tax-free because you already paid taxes on that money. It is also possible to roll over funds to an IRA account without paying tax. Furthermore, if you contributed to a traditional IRA or a Roth IRA, earnings in these accounts can grow, either tax-deferred or tax-free. Your 1099-R should indicate which is which.

Roth IRAs vs. Traditional IRAs  

There are different rules governing distributions from Roth and Traditional IRAs. Generally, contributions made to a Traditional IRA are tax-deductible, and your money grows tax-deferred. This means that distributions received from these accounts are taxed as regular income after age 59½.

Contributions made to a Roth IRA are not tax-deductible. But you can generally receive distributions from these accounts tax-free, once you have reached the age of 59½. Also, your money grows tax-free.

What’s more, with a Traditional IRA, to avoid being penalized, you need to begin taking annual Required Minimum Distributions (RMDs) from your account by April 1st of the year after you reach age 72 (70½ if you have reached 70½ before Jan 2020). On the other hand, there is no such thing as a required distribution with a Roth IRA. So, you can hold money in the account without being penalized.

Early Withdrawal Penalty  

In most cases, any distribution you receive from a pension or IRA before you reach the age of 59 ½ will be considered to be an early withdrawal. Early withdrawals are subject to an additional 10% tax at the federal level, and some states will also penalize the early withdrawal.

The early withdrawal penalty will apply to the entire amount of the distribution unless it qualifies for an exemption. Some common exemptions exist when:

  • You are disabled;
  • Age 59½ or older;
  • Using the money to purchase your first home; and
  • Withdrawing from an inherited Roth IRA

How to Estimate How Much to Withhold

A lot goes into how much income tax you owe, but there is a way to roughly estimate how much retirement income you need to withhold to cover your tax bill:

Suppose that in a given year, your income was $30,000 from a pension plan and $40,000 from an IRA. Using your 1099-R, you can prepare a tax projection (a “pretend” tax return that is not filed) to learn that your tax bill is $7000.

Since this $7000 represents 10% of your total income, 10% in federal taxes should be withheld from your pension and IRA withdrawals. In other words, you should only receive $27,000 from your pension plan and $36,000 from your IRA.

Consulting with a tax professional is the only way to find out exactly how much you will owe in taxes when you file your tax return. But, if you are looking for a basic estimate of roughly how much money to put aside to cover your tax bill, then this method can be useful.

For more information regarding pensions and taxes, trust the advice of a qualified, knowledgeable professional. An experienced professional can help you determine how federal income tax rules apply to your pension income. Call us today to arrange a free consultation.

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