Retirement lets you escape the daily grind. No more commuting in rush-hour traffic. No more dealing with a flooded inbox and a constantly ringing telephone. But there's one thing you won't escape, and that's the burden of paying taxes on your earnings. Yes, the pension you've earned through years of hard work may be taxed, depending on how your employer deposited the funds. In order to avoid costly penalties, you'll need to estimate your taxes and pay one-fourth of the total amount in four payments in January, April, June and September of each year.
Determining Taxable Earnings
Whether you owe taxes on your pension depends entirely on how it was taxed when it was first deposited into the plan. If your company contributed 100 percent toward your pension, the full amount will be taxable when you take it out. However, if you contributed toward your pension, you'll need to determine whether or not you paid taxes on that money when it was paid in. If not, taxes will be due when you take the money out.
From there, things get a little complicated, though. If your contribution was made from already-taxed dollars, you may still owe tax. The tax you paid over the course of your working life must cover the money you're taking out during your golden years. So you still need to use Form 1040-ES to calculate how much you should pay quarterly to avoid penalties.
Making Quarterly Payments
Once you begin receiving pension payments, you'll get a Form 1099-R in the mail each year, which shows how much you contributed to your pension plan and how much you'll owe in taxes. If you take your pension in one lump sum, you'll owe all the taxes in the year you withdraw it. Otherwise, it will be taxed each year.
To avoid paying penalties at tax time, the IRS recommends that you make quarterly payments on any taxes you owe on earnings like pension income. Form 1040-ES gives information on current tax rates, along with quarterly payment due dates and information on where to send your payments and vouchers. You can use the worksheet on this form to calculate how much you'll owe in taxes at the end of the year, then divide that amount by four on Line 15 to get your recommended quarterly payment amount.
If you need help estimating your quarterly taxes, the IRS offers free taxpayer assistance through its hotline at 800-829-1040 or at one of the taxpayer assistance centers located in most major cities throughout the U.S.