There’s at least one thing sure in life, both before and after retirement: taxes. If you receive retirement income, you’ll need to determine what taxes you owe on that money to avoid an unpleasant surprise on Tax Day. You might then assume that the answer to “Is pension income taxable?” is pretty straightforward.

But are pensions taxable? Yes and no. The answer depends on whether you paid taxes on the money before contributing it to your retirement fund. If not, you’ll owe taxes. This article will help you better understand pensions and annuities and their taxability.

What Are Pensions and Annuities?

When you someday prepare to retire, your first course of action will likely be to gather information on all of the retirement income you’ll get. Some of this may be in the form of 401(k) plans or IRAs. But if you’re a government worker or one of the 15 percent of private-sector employees who will receive pension income from an employer, you’ll also be eligible for regular payments or a lump sum payment.

But before you start researching whether pension income is taxable, it’s essential to consider another kind of retirement income: annuities. An annuity can issue a monthly payment like a pension after you stop working. If you have an annuity, that means you signed a contract with an insurer at some point earlier in life and will receive payments under the terms of that contract.

It’s essential to look at how pensions are taxed. With all retirement income, whether you pay taxes or not depends on whether you paid taxes when you put the money into the account. The IRS will get its money one way or another, so if you didn’t pay taxes when the money went in, you’ll pay taxes when you take it out.

How Are Pensions and Annuities Taxed?

Your retirement income may be subject to a pension tax, typically taken out of your payment. You can choose not to have income tax withheld from your pension payments however you’ll still owe taxes on the funds. If you go this route, you might need to make quarterly payments to avoid underpayment penalties at tax time.

As with retirement savings, when you look at how annuities are taxed, it depends on whether the money went into the annuity before or after you paid taxes. The IRS divides annuities into two categories:

• Qualified annuity — With a qualified annuity, you put the money into the account without paying taxes. The IRS allows this with the understanding that you’ll pay taxes when you take the money out of the account. That means you’ll owe taxes on the funds, whether you have it taken out of your payments or opt to pay them directly to the IRS.

• Non-qualified annuity — When you put money into your account after paying taxes, you enjoy tax-free distributions at retirement. In this case, “Is annuity income taxable?” can be answered with “no.” You won’t pay taxes on any money you receive. But if your non-qualified annuity grows beyond the funds you contributed, that growth amount is taxed at ordinary income tax rates. Earnings on the annuity contribution are always taxable.

According to IRS publication 575, two methods determine how you’ll pay taxes on the taxable portion of your pension or annuity. The General Rule applies if you began taking payments before November 19, 1996. For most people, though, the Simplified Method will be used to calculate the taxable portion of your annuity.

How the General Rule Works

If your pension began before November 19, 1996, you’ll need to use the General Rule to determine the tax-free portion of your retirement income. For most, though, the Simplified Method will be a better option.

To calculate your 1099-R taxable amount using the General Rule, you’ll need the worksheet provided as part of Publication 939. Under this rule, you use the actuary tables provided in that publication, designed to calculate your tax debt based on your life expectancy. If you’d prefer, you can pay a fee to have the IRS issue a ruling on the amount you should pay.

How the Simplified Method Works

As the name implies, the Simplified Method provides a more straightforward way to calculate your pension. Instead of dealing with actuary tables, you’ll use the Simplified Method worksheet to determine how much of your retirement income is taxable.

With the Simplified Method, the 1099-R taxable amount calculation has you performing a calculation based on the contributions you made and the total number of monthly payments you’re expecting to receive. If your annuity is payable for the remainder of your life, you’ll use a primary estimated number of payments based on your age in a simple table provided on the worksheet.

Bottom Line

Are annuities taxable? The answer depends on a variety of factors. We recommend working with a qualified financial advisor who can help you determine how much you’ll owe in taxes and how to maximize your income to enjoy retirement.

Frequently asked questions

Is all income from pensions and annuities taxable?

The taxability of income from pensions and annuities depends on the source of the funds and how the contributions were made. If contributions were made with after-tax dollars, a portion of your pension or annuity payments might be tax-free. However, your pension or annuity is likely fully taxable if contributions were pre-tax or deducted from your income.

How is pension income taxed?

Pension income is taxed as ordinary income at your current tax rate if the contributions were made pre-tax. If you made after-tax contributions to your pension, a part of each payment is considered a return of your after-tax contribution and is not taxed.

What is the "Simplified Method" for annuities?

The IRS provides a Simplified Method for non-qualified plans to calculate the taxable portion of annuity payments. This method applies to annuities that started after November 18, 1996, and involves dividing your total after-tax contributions by the number of anticipated monthly expenses to determine how much of each payment is not taxable.

Can I roll over my pension or annuity into an IRA to avoid taxes?

You can roll over your pension or annuity into an IRA to defer taxes, but this depends on the type of plan. Direct rollovers from a qualified plan to an IRA can defer taxes until you start withdrawing from the IRA.

Are there any special tax rules for government or military pensions?

Yes, certain government and military service pensions may have unique tax rules. For example, a portion of military retirement pay may be tax-exempt if received for combat-related injuries.

What happens if I withdraw money from my annuity before age 59½?

Early withdrawals from an annuity may be subject to a 10% penalty in addition to ordinary income tax. However, there are exceptions to this penalty, such as payments made due to disability or certain annuity payment schedules.

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