When transitioning into retirement, understanding your financial landscape is crucial. A common question we often encounter is, 'Is a retirement pension considered income?' This query pertains to how the government classifies your retirement pension for tax purposes. To simplify, most pensions, particularly those funded with pre-tax dollars, are considered income when disbursed.
Let’s begin by examining what a pension is and how pensions compare to other retirement income sources. A retirement pension is a plan offered through an employer that is usually paid out in fixed payments once you retire. A pension is funded by an employer, and the payout is based on several things, like years of employment, salary, and age at retirement. These plans are called defined benefit plans. In contrast, newer options like 401(k) plans are called defined contribution plans.
With a pension, the employer pays the amount promised to all eligible retirees. This is no matter how well or poorly the plan's investments perform. This is one reason pensions have decreased in usage and have been replaced with defined contribution accounts. With a defined contribution plan like a 401(k), the employer is responsible for making the contributions as agreed but has no liability for long-term payments.
Unlike 401(k) plans or other individually managed retirement accounts like IRAs, most people do not contribute to their pension plan. However, in some government or nonprofit agencies where these traditional pensions still exist, some include employee contributions.
The IRS defines gross income as wages, dividends, capital gains, business income, retirement distributions, and other income. But the IRS allows adjustments to gross income, which are subtracted to arrive at your taxable adjusted gross income, called AGI. The adjustments include contributions to a retirement account, certain alimony payments, student loan interest, and specific educator expenses.
That means pension payments are part of your income, as are withdrawals from a traditional IRA or employer-sponsored 401(k) account. What is excluded from your AGI are Roth IRA withdrawals. The exclusion is because contributions to Roth IRAs are made with funds you have already paid income taxes on.
It’s helpful to note that some military or government pensions are exempt from taxes, typically when retirement is due to disability.
Earned income (usually obtained from wages and business activity) is separate from investment growth income, called capital gains income. Earned income is also known as ordinary income, which is taxed at a higher rate than income from long-term capital gains. Long-term capital gains are the profit from selling an asset (like real estate or stock) you have owned for over a year. If you sell an investment you have held for less than one year, any gain is taxed at the ordinary income rate.
While pensions are usually paid out in monthly increments, some retirement plans offer lump-sum payments. While an investor may be tempted to take a lump sum payment for several reasons, it’s vital to remember that taxes will be due on the entire amount in the tax year in which the payment is made.
Also, some states apply income tax to pension payments, while others do not. Check with your tax advisor regarding state rules.