Pension distributions may be classified as fully or partially taxable, or tax-free, depending on how the original contributions were made. For taxpayers participating in tax-deferred pension plans, as opposed to plans funded all or in part with after-tax dollars, their payments are considered fully taxable. Pension administrators typically figure the taxable amounts and report income on Form 1099-R. IRS Publication 575 provides comprehensive guidelines on pension distributions and their applicable tax parameters.
Income Tax Withheld
Participants in pension plans will generally have the applicable income tax withheld from their distributions. This also applies to other forms of retirement income such as individual retirement accounts, annuities and profit-sharing plans. How much is withheld depends on whether payments are distributed over multiple years, considered periodic payments, or within a single year. Under certain circumstances, the IRS also allows taxpayers to elect not to have taxes withheld by filling out Form W-4P, which is the Withholding Certificate for Pension or Annuity Payments. Eligible pension recipients should consult their plan administrator for rules and options specific to their own situations.
Nontaxable Pension Distributions
Pension participants whose plan consists solely of after-tax dollars are not subject to income tax on their distributions, which are considered simply a return of their own retirement investments. Accordingly, no income tax is withheld from those payments. Employees and executives may choose fund their plans with money taken from their paychecks after all deductions, a choice dictated by their assets, income, liabilities and other financial considerations.
Taxable Pension Distributions
Pension payments are considered entirely taxable if participants did not pay any amounts into their plans or if their employers did not deduct any contributions made from salaries. Tax-deferred contributions become taxed at the time of receipt rather than when actually earned. Certain plans may provide for initial tax-free distributions followed by taxable amounts depending on how those accounts are structured. Plan administrators are generally responsible to properly account for all taxes due.
Partly Taxable Distributions
Pension holders who made after-tax contributions need not pay taxes on that amount of their distributions, which amount to a return of their own money. Additional funds contributed by employers, in addition to interest or capital gains that have accumulated from after-tax money, are subject to income tax. Those who elect to receive pension payments before reaching age 59 1/2 may have to pay a 10 percent penalty, subject to exclusions caused by disability and other considerations.