Yes, most pensions are taxable as ordinary income

The short answer: most of the money you receive from a pension is subject to federal income tax, and often state income tax too. The amount you owe depends on how much you contributed to the pension yourself versus how much your employer contributed, and whether the pension came from a traditional plan or a Roth plan.

When you worked, your employer may have withheld taxes from your paycheck as contributions went into the pension. The portion that came from your own after-tax contributions is not taxed again when you withdraw it. But the portion that came from your employer's contributions, plus all the investment growth, is taxed as income in the year you receive it.

The IRS treats pension payments the same way it treats wages: they count toward your total income for the year, which determines your tax bracket and how much you owe. You will receive a Form 1099-R each January showing how much was paid out the previous year, and you report that on your tax return.

Key Takeaways

  • Employer contributions to your pension and all investment growth are taxed as ordinary income when you receive the money.
  • Your own after-tax contributions to the pension are not taxed again, but you need records showing how much you contributed.
  • The IRS requires your pension payer to withhold federal income tax automatically unless you choose not to, and you can adjust the withholding amount.
  • Some states do not tax pension income at all, while others tax it fully or offer partial exemptions for certain types of pensions.
  • 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 much of your pension is actually taxable

The taxable portion of your pension depends on what you paid into it. If you contributed money from your own paycheck after taxes were already taken out, that portion comes back to you tax-free. The rest — your employer's contributions plus all the earnings those contributions generated — is taxable.

To figure out your taxable amount, you need to know your cost basis, which is the total of your own after-tax contributions over the years. If you have old pay stubs or pension statements showing contributions, gather those. If you cannot find them, contact your pension plan administrator and ask for a statement of your contributions. They are required to provide this information.

Once you know your cost basis, the IRS uses a formula called the Simplified Method (for most people) or the General Rule (if you have a very large pension or received a lump sum). Your pension payer or a tax professional can help you calculate which applies to you. The calculation determines what percentage of each payment is taxable, and that percentage stays the same for the life of the pension.

Federal tax withholding on pension payments

When your pension starts, the payer is required by law to withhold federal income tax from each payment unless you tell them not to. The standard withholding is calculated as if you are single with no dependents, which often means too much tax is withheld — money you could have used during the year.

You can change your withholding by filling out a Form W-4P with your pension administrator. This form lets you claim dependents, request extra withholding, or ask for no withholding at all. If you choose zero withholding, you are responsible for paying the tax yourself, either through quarterly estimated tax payments or by paying a lump sum when you file your return.

Many people adjust their withholding after the first year once they see how much tax they actually owe. If too much was withheld, you get a refund when you file your return. If too little was withheld and you owe money, you may owe penalties if the shortfall was large.

State income tax on pensions

Whether you owe state income tax on your pension depends entirely on which state you live in. Some states do not tax pension income at all. Others tax it fully as ordinary income. A few states offer partial exemptions for certain types of pensions, such as military pensions or pensions from public employees.

If you moved to a new state after you started receiving your pension, you may owe taxes to your old state on the portion of the year you lived there, depending on that state's rules. Some states have reciprocal agreements that prevent double taxation, but you still need to file in both states to claim the exemption.

Your pension payer may not withhold state income tax automatically, even if they withhold federal tax. You may need to make quarterly estimated state tax payments yourself, or you can ask your pension administrator to withhold state tax if they offer it. Check your state's tax agency website or ask a tax professional what applies to your situation.

Roth pensions and tax-free withdrawals

A Roth pension is rare, but if you have one, the rules are different. Money you contributed to a Roth pension comes out tax-free. The investment growth also comes out tax-free, as long as you have held the account for at least five years and you are age 59½ or older when you start withdrawals.

If you withdraw from a Roth pension before age 59½, the earnings portion (but not your contributions) may be subject to income tax and a 10 percent penalty. The five-year rule is separate from the age rule — both must be met for the entire withdrawal to be tax-free.

Most pensions are traditional, not Roth, so check your pension documents or ask your administrator which type you have. If you are unsure, assume it is traditional and taxable unless you see "Roth" in the plan name or documents.

Early withdrawal penalties and exceptions

If you withdraw money from your pension before age 59½, you generally owe a 10 percent early withdrawal penalty on top of regular income tax. This penalty applies to the taxable portion of the withdrawal.

Some pensions have exceptions to this penalty. If you are receiving Substantially Equal Periodic Payments (SEPP) — a series of equal withdrawals calculated using IRS formulas — you can avoid the penalty even before age 59½. If you become disabled or are receiving the pension as a beneficiary after the original owner's death, the penalty may not explore. If you are a public safety officer (police, firefighter, or certain other roles), you may be able to withdraw at age 50 without penalty.

These exceptions are specific and have strict rules. If you think one might explore to you, talk to a tax professional or contact your pension administrator before you withdraw, because paying the penalty and then trying to get it refunded is much harder than avoiding it in the first place.

Reporting pension income on your tax return

Your pension payer sends you a Form 1099-R by January 31 each year, showing the total amount paid and the taxable amount. You report this on your federal tax return, usually on Form 1040. If you received more than one pension, you will receive multiple 1099-R forms and report each one.

The 1099-R also shows how much federal tax was withheld. If you withheld too much, you get a refund. If you withheld too little, you owe the difference. Some people owe additional tax beyond what was withheld because their pension pushed them into a higher tax bracket, or because they have other income.

Keep your 1099-R forms for your records. If you made after-tax contributions to your pension and are claiming them as non-taxable, you may need to file Form 8606 with your return to document your cost basis. A tax professional can help you determine whether you need this form.

Frequently Asked Questions

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

No. Only the portion that came from your employer's contributions and investment growth is taxable. Your own after-tax contributions come back to you tax-free. You need documentation of what you contributed to prove this to the IRS.

Can I reduce the amount of tax withheld from my pension?

Yes. Fill out Form W-4P with your pension administrator to claim dependents, request lower withholding, or request no withholding. If you choose no withholding, you are responsible for paying the tax through quarterly estimated payments or when you file your return.

What happens if I take my pension as a lump sum instead of monthly payments?

The entire taxable portion is taxable in the year you receive it, which may push you into a higher tax bracket and result in a larger tax bill than if you took monthly payments. Some plans allow you to roll a lump sum into an IRA to spread the tax over time, but you must do this within 60 days.

Is my military pension taxed differently?

Military pensions are taxed as ordinary income federally, but some states exempt military pensions from state income tax. Check your state's rules. If you are receiving a military pension and also working, both income sources count toward your total taxable income.

What if I moved to a state with no income tax after I started my pension?

You generally do not owe state income tax on your pension in your new state if it has no income tax. You may still owe tax to your old state for the portion of the year you lived there, depending on that state's rules. File in both states if required and claim any exemptions you are due.