Pensions are taxed as ordinary income in the year you receive them

When you withdraw money from a pension, the IRS treats it the same way it treats wages from a job. You pay federal income tax on the full amount you take out, at whatever tax bracket you fall into that year. The tax is not a flat rate — it depends on your total income and your filing status.

The key difference from a paycheck is that your pension payer does not automatically withhold taxes unless you ask them to. Many people receive a pension check with no tax taken out, then owe a large bill at tax time. You can request withholding when you start taking payments, or you can pay estimated taxes quarterly to avoid a surprise.

Key Takeaways

  • Pension withdrawals are taxed as ordinary income at your marginal tax rate, not at a special pension rate.
  • Your pension payer will not withhold taxes automatically unless you fill out a withholding form and return it to them.
  • Some pensions are only partly taxable if you contributed your own money to the plan before retirement.
  • State income tax may also apply to your pension, depending on which state you live in and which state the pension is from.
  • If you withdraw money before age 59½ from certain types of pensions, you may owe a 10 percent early withdrawal penalty on top of income tax.

How withholding works and what forms to use

When you start receiving a pension, your pension administrator will send you a form called the W-4P. This is the withholding election form for pensions. You fill it out to tell the payer how much federal tax to hold back from each check. If you do not return the form, most pensions will withhold taxes as if you claimed zero dependents — which usually means a large amount comes out.

You can change your withholding at any time by submitting a new W-4P. If you realize mid-year that too much or too little is being withheld, you do not have to wait until next year. Contact your pension payer's benefits department directly and ask for a new withholding form.

The amount you should withhold depends on your total household income, not just the pension. If you have a spouse who works, or if you have other income sources, you may need to withhold more from your pension to cover all your taxes. The IRS provides a withholding calculator on its website (irs.gov) to help you estimate the right amount.

Taxable versus non-taxable portions of your pension

If you contributed your own after-tax money to your pension plan while you were working, part of your pension is not taxable. The IRS calls this the basis or cost basis — the money you already paid tax on once.

To figure out how much of each check is taxable, you need to know three things: the total amount you contributed out of your own pocket, the total value of your pension account when you start withdrawing, and how long you are expected to live (based on IRS life expectancy tables). Your pension payer should calculate this for you and tell you the non-taxable portion. If they do not, ask them for a basis calculation or cost basis statement.

Most people who receive pensions from employers never contributed their own money, so their entire pension is taxable. Military pensions, federal employee pensions, and some union pensions work this way. If you are unsure whether you contributed, check your old pay stubs or ask your pension payer's benefits department.

State income tax on pensions

Some states do not tax pension income at all. Others tax it like any other income. A few states tax only certain types of pensions — for example, some exempt military pensions but tax others.

The state that taxes your pension is usually the state where you live when you receive it, not the state where you worked. If you move to a state with no income tax after you retire, you may not owe state tax on your pension going forward. However, if you move to a state that does tax pensions, you will owe state tax even if the pension is from a different state.

Check your state's tax authority website or ask your pension payer whether your pension is subject to state tax. Some pension payers will withhold state tax if you request it on a state withholding form, similar to the federal W-4P.

Early withdrawal penalties and exceptions

If you withdraw money from certain types of pensions before age 59½, you may owe a 10 percent early withdrawal penalty on top of regular income tax. This applies to IRAs, 401(k)s, 403(b)s, and similar defined-contribution plans.

Traditional employer pensions (called defined-benefit plans) usually do not have an early withdrawal penalty if you take the money after you have separated from the employer, even if you are under 59½. However, the money is still taxed as ordinary income.

Some exceptions exist to the 10 percent penalty. You may avoid it if you are disabled, if you are taking substantially equal periodic payments over your lifetime, or if you are paying for certain medical expenses. The rules are specific to each type of plan. Ask your pension payer or a tax professional whether an exception applies to you.

What happens if you do not withhold enough tax

If your pension payer does not withhold enough tax during the year, you will owe the difference when you file your tax return. You may also owe estimated tax penalties if you underpaid by a large amount. These penalties are separate from the tax itself and can add several hundred dollars to your bill.

To avoid penalties, the IRS requires you to pay either 90 percent of your current year's tax or 100 percent of your prior year's tax (whichever is smaller) by the end of the year. If you are over 65, the threshold is slightly lower. If you think you will underpay, you can make quarterly estimated tax payments to the IRS instead of waiting until April.

Lump-sum distributions and special tax rules

If your pension plan allows you to take all your money at once instead of monthly payments, that is called a lump-sum distribution. The entire amount is taxable in the year you receive it, which can push you into a higher tax bracket.

Some lump-sum distributions may have access to for forward averaging, an older tax rule that lets you spread the tax over multiple years on your return. This rule applies only to certain pensions and only if you were born before 1936. If you are considering a lump-sum distribution, ask your pension payer or a tax professional whether forward averaging is available to you.

If you roll a lump-sum distribution into an IRA or another retirement plan within 60 days, you can defer the tax. However, if you take the money and do not roll it over, the full amount is taxable immediately.

Frequently Asked Questions

Do I have to pay taxes on my entire pension check?

Usually yes, unless you contributed your own after-tax money to the plan. Even then, only the portion you contributed is tax-free; the rest is taxable. Ask your pension payer for a basis calculation to find out how much of each check is taxable.

What if I do not fill out the W-4P withholding form?

Your pension payer will withhold taxes as if you claimed zero dependents, which typically means a large amount comes out of each check. You can change this at any time by submitting a completed W-4P form to your pension payer's benefits department.

Can I avoid the 10 percent early withdrawal penalty?

It depends on the type of pension and your circumstances. Defined-benefit employer pensions usually have no penalty after you leave the job. IRAs and 401(k)s have exceptions for disability, substantially equal payments, and certain medical expenses. Ask your pension payer whether an exception applies.

Will I owe state income tax on my pension?

It depends on which state you live in and which state the pension is from. Some states do not tax pensions; others tax them fully. Check your state's tax authority website or ask your pension payer whether state tax applies to you.

What is the difference between a lump-sum distribution and monthly payments?

A lump-sum is all the money at once, taxed in one year, which can push you into a higher bracket. Monthly payments spread the tax over many years. A lump-sum can be rolled into an IRA within 60 days to defer taxes, but monthly payments cannot.