Pension Income and Taxes: What You Need to Know

If you're receiving a pension from a former job, will you be taxed?

Everyone looks forward to retirement. Time to relax, and hopefully, reap the benefits of a lifetime of hard work. Maybe you have a pension waiting for you when you're ready. Your pension is part of your income, and you've been paying income tax since your first job. So you might be wondering whether your pension going to be taxed, too.

A pension is a benefit -- a commitment an employer makes to pay you a specific amount of money for the rest of your life after you retire. The employer uses a firm to manage pension investments, so you don't need to do anything but show up for work.

If you leave a job before you retire, you may or may not receive a pension. It depends on factors like how long you worked for the company and whether or not your pension has "vested" according to the employer's schedule. "Vesting" means you must stay with an employer for a certain number of years before you have access to your pension. It's usually around five years, but varies depending on the company. With some employers, the amount of the pension increases the longer you stay.

Once you start receiving your pension, the IRS regards it as income and you'll pay taxes on it accordingly, on the federal level. Check the tax laws in your state to see how it handles pension income, because it can vary widely.

Pretax and post-tax contributions to your pension make a difference. If a portion of your paycheck goes to your pension fund pretax (before paying income tax on it), this lowers your adjusted gross income and lowers your federal tax bill each year that you're working. But your future pension payouts will still be fully taxable [source: Schnotz].

If you contribute a portion of your pay to your pension fund post-tax, you're entitled to receive some of your pension tax-free. This is because you already paid taxes on your contributions. When you do your taxes, the IRS provides you with a calculation to figure out how much of your pension is tax-free and how much is taxable.

When you select your pension, you should also consider your choice of a lump sum payout or recurring annuity payments after you retire. You pay taxes either way. However, choosing a lump-sum payment could possibly bump you into a higher tax bracket -- which could cause you to pay more taxes than you would with periodic payments. Some retirees opt to make quarterly estimated tax payments or have federal taxes withheld so there aren't any surprises come tax time.

You may also have to pay an additional 10 percent tax for withdrawing your pension before retirement age, unless you qualify for an exception. The IRS website explains the exceptions in more detail.

If you also have other retirement savings accounts, like a 401(k), it's wise to work with an accountant to find out how much you'll be giving to Uncle Sam when you retire.