Pensions are retirement plans that allow workers to save for the period late in life when they will no longer be working. Though you theoretically receive your pension during retirement, you will still be responsible for income taxes on most of those pension distributions. Because you received preferential tax treatment when you made contributions to your retirement account, the IRS collects on the back-end at distribution. However, certain retirement accounts require you to forgo the preferential tax treatment on the contributions and not pay tax on the distributions.
Taxation of Pension Distributions
Pensions and retirement plans generally reduce a taxpayer's taxable income during his working years. The tax code provides that any amount distributed to a pensioner from a qualified pension plan will be taxable to the recipient in the year distributed. Distributions are considered ordinary income.
Tax Treatment Based on Distribution Type
If you receive your pension distribution as an annuity or other periodic payment, you may choose to have income tax withheld from your payment. To have the proper amount withheld, you should provide the payer with a Form W4-P, Withholding Certificate for Pension or Annuity Payments. If you do not submit this form, the payer must withhold based on specifications form the Internal Revenue Service. These tend to withhold more than you may need to have withheld. If you receive your pension distribution as a lump sum distribution, the payer must automatically withhold 20 percent of the distribution unless you are eligible for a tax-free rollover.
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Tax Treatment of Rollovers
If there is an eligible rollover distribution, the taxpayer can defer tax on that distribution until the taxpayer takes an actual distribution. To make an eligible rollover distribution, the distribution must be made from a qualified retirement plan to another qualified retirement plan. However, an eligible rollover distribution cannot be made of a series of substantially equal distributions, any required minimum distributions under law, hardship distributions, corrective distributions of excess contributions or deferrals, loans, dividends of employer securities or the cost of life insurance.
Tax Treatment of Roth 401ks and Roth IRAs
Roth 401k and IRAs are a special kind of retirement account as they allow post-tax contributions. In exchange for forgoing tax benefits on the contributions, pensioners receive the benefit of tax-free distributions provided they are receiving a qualified distribution. This means that the distribution will be excluded from the individual's gross income if the distribution is made on or after the individual attains age 59½, has become disabled or the individual has died.