Most pension payments are taxable income, but the amount you owe depends on how you funded the plan
Whether you pay federal income tax on your pension depends on whether you or your employer paid for it with pre-tax or after-tax dollars. If your employer contributed the money before taxes were taken out of your paycheck — the most common setup — you owe federal income tax on the full amount you receive each month. If you contributed after-tax dollars yourself, only the portion that came from employer contributions or investment gains is taxed.
The IRS requires pension administrators to withhold federal income tax from your payments unless you tell them not to. Most people have 10 to 20 percent withheld automatically. You can change your withholding amount by filling out a new W-4P form with your pension plan administrator, though changing it does not change what you ultimately owe — it only changes how much comes out of each check.
State and local income taxes may also apply, depending on where you live and where the pension is paid from. Some states do not tax pension income at all, while others tax it the same way they tax wages. You should check your state's tax rules or speak with a tax preparer about your specific situation.
Key Takeaways
- Pensions funded with pre-tax employer contributions are fully taxable as ordinary income in the year you receive them.
- If you contributed after-tax money to your pension, only the employer portion and investment gains are taxed, not your own contributions.
- Federal income tax is normally withheld automatically from pension payments, but you can request a different withholding amount on Form W-4P.
- State and local taxes on pensions vary by location — some states exempt pension income entirely, while others tax it like regular wages.
- You report pension income on your federal tax return each year, and the pension administrator sends you a Form 1099-R showing the taxable amount.
How the tax treatment differs between employer-funded and employee-funded pensions
If your employer paid the full cost of your pension with money deducted before your taxes were calculated, the entire pension payment is taxable. This is true whether the money went into a traditional defined-benefit pension (the kind that pays you a fixed monthly amount) or a defined-contribution plan like a 401(k). The tax is owed in the year you receive the money, not when it was originally contributed.
If you contributed your own after-tax money to the pension — meaning you paid income tax on it when you earned it — you do not owe tax again on that portion when you receive it. However, you do owe tax on the employer's contributions and on any investment earnings the account generated. Your pension administrator can tell you what portion of your total contributions came from your own after-tax payments. This is called your cost basis, and it is not taxed a second time.
The calculation works like this: if you contributed $50,000 after taxes and your total pension balance is $200,000, roughly one-quarter of each payment you receive is your own money (not taxed) and three-quarters is taxable. The exact percentage depends on how long you live and how much you receive in total, which is why the IRS has specific rules for calculating this.
Federal income tax withholding and how to change it
When you start receiving pension payments, your plan administrator automatically withholds federal income tax. The amount withheld is based on the W-4P form you complete when you begin taking distributions. If you do not fill one out, the administrator withholds as if you are single with no dependents, which often results in more tax being withheld than you actually owe.
You can reduce or increase your withholding by submitting a new W-4P to your pension administrator at any time. Lowering your withholding means more money in each check but a larger tax bill when you file your return. Raising it means smaller checks but less owed at tax time. Some people choose to have no federal tax withheld at all, though this requires you to pay the full amount when you file your return or make quarterly estimated tax payments to the IRS.
Withholding is not the same as the tax you owe. If you have $1,000 withheld from your pension but only owe $800 in total tax, you get a refund when you file. If you have $500 withheld but owe $800, you must pay the difference. The withholding is simply an advance payment toward your tax bill.
State and local taxes on pension income
Thirteen states do not tax pension income at all: Alaska, Florida, Illinois, Iowa, Kansas, Louisiana, Mississippi, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming. If you live in one of these states, you owe no state income tax on your pension, though you still owe federal tax.
Most other states tax pensions as ordinary income, meaning the same tax rate applies to your pension as to wages or other income. A few states offer partial exemptions — for example, some allow you to exclude a certain dollar amount of pension income, or they tax pensions at a lower rate than wages. The rules vary significantly, so you should check your state's tax agency website or speak with a tax preparer about your state's specific rules.
If you receive a pension from a plan in one state but live in another, you may owe tax in both places, though most states have agreements to avoid double taxation. The state where the pension plan is based usually has the primary claim to tax it, but your home state may also tax it. This is another reason to consult a tax preparer if your situation is complex.
The Form 1099-R and reporting your pension on your tax return
Your pension administrator sends you a Form 1099-R each January showing how much you received in the previous year and how much federal tax was withheld. This form breaks down the taxable amount, any non-taxable portion (such as your after-tax contributions), and whether the distribution qualifies for any special tax treatment. You use this form to report your pension income on your federal tax return.
You report the taxable amount from Box 2a of the 1099-R on your Form 1040 as pension income. If you received distributions from multiple pensions, you receive multiple 1099-Rs and report each one. The IRS matches the information on your return to the copies of the 1099-R they receive from the pension administrators, so the amounts must match.
If you received a lump-sum distribution — a single large payment instead of monthly checks — the tax treatment may be different. Some lump-sum distributions may have access to for special averaging rules that can lower your tax, though this is less common than it once was. Your 1099-R will indicate if your distribution qualifies for this treatment.
Early withdrawal penalties and exceptions
If you withdraw money from your pension before age 59½, you normally owe a 10 percent early withdrawal penalty on top of regular income tax. However, several exceptions exist. If you are separated from service (no longer working for the employer), you can take withdrawals without penalty once you reach age 55. If you are disabled or receiving distributions as part of a may have access to domestic relations order (a court order related to divorce), the penalty does not apply.
Some pension plans also allow substantially equal periodic payments (SEPPs), which let you withdraw money before 59½ without penalty if you commit to taking equal amounts for at least five years or until age 59½, whichever is longer. This is a complex calculation, and mistakes can result in penalties, so you should work with a tax professional if you are considering this option.
The early withdrawal penalty applies only to the taxable portion of your distribution. If part of your pension is non-taxable (because it came from your after-tax contributions), the penalty applies only to the taxable part.
What happens if you do not have enough tax withheld
If your pension withholding is too low and you owe more tax than was withheld, you must pay the difference when you file your return. If you owe a large amount, the IRS may charge you a penalty for underpayment of estimated tax, especially if you underpaid throughout the year. You can avoid this penalty by increasing your withholding on Form W-4P or by making quarterly estimated tax payments.
If you have other income besides your pension — such as Social Security, investment income, or part-time work — your total tax bill may be higher than your pension withholding accounts for. In this case, you may need to increase your pension withholding or make estimated payments to cover the additional tax on your other income.
You can adjust your withholding at any time during the year, so if you realize mid-year that you are underpaying, you can submit a new W-4P to increase withholding for the remaining months.
Frequently Asked Questions
Do I have to pay taxes on my entire pension if I contributed some of my own money?
No. Only the portion that came from your employer's contributions and investment earnings is taxed. The portion that came from your own after-tax contributions is not taxed again. Your pension administrator can calculate this for you using your cost basis.
Can I choose not to have federal tax withheld from my pension?
Yes, you can request zero withholding by submitting a new W-4P form. However, you will owe the full tax amount when you file your return or must make quarterly estimated payments to avoid penalties. Most people find it easier to have some withholding taken out each month.
What if I move to a state with no pension tax after I start receiving my pension?
You will owe no state tax on your pension going forward, but you may still owe state tax to your former state for the year you moved, depending on when during the year you relocated. Check with both states' tax agencies about your specific situation.
Is my pension taxed differently if I take it as a lump sum instead of monthly payments?
The income is taxed the same way, but a lump sum may may have access to for special averaging rules that can reduce your tax bill. Your 1099-R will show if your distribution qualifies. A tax preparer can calculate whether averaging saves you money.
What if I inherit a pension from someone else?
Inherited pensions are taxed to you as income in the year you receive distributions, though the rules depend on your relationship to the original owner and the type of plan. Spouses have different options than non-spouse beneficiaries. Consult a tax professional about your specific situation.