If you have a pension, you’re one of the lucky ones. Defined benefit retirement plans like pensions are increasingly rare, having been largely replaced by defined contribution plans like the 401(k). But drawing on your pension income when you hit retirement isn’t a free ride. Some or all of that pension will be taxable. A financial advisor could help you optimize your tax strategy to benefit your retirement. Here’s how it works.
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The terms of your pension will include a retirement age at which you can start claiming pension income. It’s usually 65, but your pension might be different. However, as with Social Security, you can start claiming reduced benefits at an earlier age. The people who administer your pension plan should be able to print you a benefits schedule that shows you how your pension income will vary based on when you claim.
You can claim your pension in a lump sum when you retire or opt to have it “annuitized” into monthly payments that will last as long as you live. Taking a lump sum means the money is safely in your hands and won’t disappear if the company folds or defaults on its pension obligations. You can invest it as you see fit or will it to your heirs so they’ll get your full pension if you pass on.
But with a lump sum you run the risk of overspending and finding yourself with no money in your old age. Opting for monthly payments will keep you safe from yourself, but leaves you more vulnerable to changes in the fortunes of your company. It also means you can’t make your own decisions about how to invest the money or leave the full amount to your heirs.
Related Article: What Is a Pension Plan?
Regardless of whether you opt to take your pension income in a lump sum or in monthly payments, it’s good to have a tax strategy. Unless you contributed to your pension, the entirety of your pension income will be taxable at your regular income tax rate. In other words, if your pension income all comes from money your employer contributed, with no additional contributions on your part, it’s all fully taxable.
According to the IRS, your pension income is fully taxable if any of the following applies to you:
If you contributed after-tax dollars to your pension, your pension will be partially taxable. You won’t owe taxes on the amount you contributed in after-tax dollars.
If you take distributions from your pension before age 59 1/2, you may owe a 10% penalty on top of your regular income taxes. The only way you can get out of this early withdrawal penalty is:
If you’re considering making an early withdrawal and you’re not sure whether you would trigger the 10% penalty it’s a good idea to check with the company that administers the plan before you take the plunge.
If you opt for monthly pension payments, you won’t be able to lessen your tax burden by easing up on withdrawals like you could with a 401(k) or an IRA. Your monthly pension payments might amount to more money than you really need and all of it will be taxable. If you had the same amount of money in an IRA or 401(k) you could delay withdrawals, opt for a smaller monthly income and enjoy more tax-free growth on your retirement fund. Still, most people would rather have a pension from their employer’s money than a 401(k) from their own.
You can ask the company that administers your pension to withhold income taxes from your pension if you’re afraid you’ll get slammed with a big bill at tax time. Withholding, which you can request on IRS Form W-4P, will let you pay your federal income taxes as you go, putting that money aside throughout the year rather than having to come up with it all in April. It’s comparable to the regular W-4 you give your employer for tax withholding purposes. If you don’t think enough money is being withheld from your pension, you can also make estimated tax payments.
A pension is a valuable source of retirement income and something many Americans wish they had. When you’re approaching your retirement age, it’s a good idea to work out a financial plan that will cover how much you’ll spend and that accounts for your tax bill. In the first year you start claiming pension funds, it’s wise to set aside plenty of money for your taxes so you don’t come up short at filing time.
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Amelia JosephsonAmelia Josephson is a writer passionate about covering financial literacy topics. Her areas of expertise include retirement and home buying. Amelia's work has appeared across the web, including on AOL, CBS News and The Simple Dollar. She holds degrees from Columbia and Oxford. Originally from Alaska, Amelia now calls Brooklyn home.
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