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How Much Tax Should I Withhold From My Pension?

Dan Caplinger, The Motley Fool

Over the years, a diminishing number of employers have offered pensions to their workers. Between the early 1990s and the early 2010s, pension plan availability fell roughly by half, from about one in three workers having access to a pension 25 years ago, to only one in six more recently. If you're fortunate enough to work for an employer that gives you a chance to get pension payments when you retire, it's important to know what you need to do in order to make the most of them. That way, when you decide to end your career, you'll know you'll be getting every penny available to you to last you the rest of your life.

Although pension income is a valuable retirement benefit that can supplement your Social Security benefits and make your retirement a lot more financially secure, it also comes with some extra responsibilities. Your monthly pension payment almost always counts as taxable income, and you'll need to make sure that you have enough taxes withheld from your pension payments to satisfy the Internal Revenue Service.

Deciding exactly how much of your payment to have withheld, however, can be trickier than you think, because many factors come into play. Even once you've made the right choice for your current situation, changes in circumstances can require you to recalculate the appropriate level of withholding in order to keep the IRS happy.

Keyboard with blue tax button.

Image source: Getty Images.

What is a pension?

A pension is a benefit that retirees get from their former employer that offers them fixed monthly payments after they retire. Also known as defined benefit plans, pension plans offer employees who meet certain criteria -- such as length of employment and age at retirement -- a certain percentage of their pre-retirement compensation as a monthly pension payment.

For instance, for those who work at least 25 years and retire after age 60, a pension might pay benefits based on 75% of their average monthly salary during the three highest-paying years of their careers.

The biggest benefit of the pension to retirees is that they have no responsibility whatsoever in coming up with the money that gets paid to them. It's up to each employer to contribute to and manage its pension funds in a way that will generate enough investment income and gains to cover the payments the employer is obligated to make to its retirees. That's in stark contrast to defined contribution plans, such as 401(k) plan accounts, where it's entirely up to workers or retirees to decide how to invest their retirement savings in a way that will produce the income they need.

Is my pension income taxable?

Most retirees who receive pensions from their former employers have to include the entire amount they receive as taxable income on their tax returns for the year in which they receive the pension income. If you didn't contribute anything or aren't considered to have contributed anything toward your former employer's pension plan, then the entire amount will be fully taxable, according to IRS rules. Similarly, if your employer didn't withhold any pension contributions from your salary, then you'll have to include all of your pension income on your tax return. Finally, your pension is fully taxable if you've already received any non-taxable amounts in past years.

In rare cases, the pension payments that you receive from your former employer are only partly taxable. If you contributed money on an after-tax basis toward your pension, then you won't have to pay tax on the portion of the pension payment that represents that after-tax money being returned to you. This tax topic description from the IRS goes into more details about the exact calculations necessary. But the general idea is that when you start taking your pension, you're allowed to take the total amount of after-tax money you've contributed toward your pension plan at your former employer, and then divide that amount by the number of months that the IRS tables estimate as your life expectancy.

For instance, if you've contributed $72,000 in your own money toward your pension plan and the IRS rules set 360 months as the appropriate period over which you're allowed to recover that money, then $72,000 divided by 360 -- or $200 per month of your pension -- will be treated as nontaxable return of your own pension contributions.

It's important to understand, though, that situations in which any of your pension income is not included as taxable income are few and far between. The vast majority of workers don't make after-tax contributions toward their pensions, and so the full amount of their pension payments ends up getting taxed.

Why is it so important to have the right amount of taxes withheld from my pension?

The IRS has rules about how much money you're required either to have withheld from the source or to have paid in quarterly estimated tax payments. Most taxpayers don't have to worry about this very much, because the amounts that their employers withhold from their paychecks during their careers are calculated so that it'll be enough to meet the requirements in most cases.

In general, if you have enough money withheld or you pay enough in estimated tax payments so that you owe no more than $1,000 in taxes at the end of the year, then you won't be subject to any penalties for underpaying your taxes during the year. Alternatively, if you paid at least 90% of your total tax liability as calculated at the end of the year on your current-year tax return, or if you paid at least 100% of what you owed in taxes last year, then you usually won't owe any penalties, either. Some special rules apply in certain circumstances, but they aren't relevant for most retirees receiving pensions.

The problem that comes up with those receiving pensions is that most pension recipients no longer work, so they don't have any paychecks from which to withhold taxes. The only withholding opportunity comes from having taxes taken out of your pension checks.

If you don't have enough money withheld and you don't make quarterly estimated tax payments, then you'll owe underpayment penalties. Those amounts are onerous enough that avoiding them is a smart move. If you can come up with a reasonable estimate of how much you'll owe in taxes, then you can set your pension tax withholding accordingly and be assured that you'll escape having to pay the IRS anything extra.

What's my pension tax rate?

The rate at which your pension income gets taxed is the same rate that applies to the rest of your ordinary taxable income. Unlike certain types of income, such as qualified dividends or long-term capital gains, no special tax treatment is available for pension income.

Under current law for 2018, the seven tax rates that can apply to ordinary income, including pension income, are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The income levels at which each tax rate takes effect depends on your filing status and your taxable income. The following four sets of tax brackets show the brackets where each tax rate begins and ends.

Note that the following discussion only talks about federal tax rates. The majority of states have income taxes of their own, and because the rates vary greatly from state to state, it would be too complicated to go through how pensions are taxed in each of the 50 states. However, there are states that don't tax pension income at all. These include not only the states that don't have a state-level income tax at all -- Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming -- but also other states that do have income taxes generally but that exempt pension income. New Hampshire and Tennessee only tax investment income, and several states, including Alabama, Hawaii, Illinois, Mississippi, and Pennsylvania, exempt all income from pensions for state-tax purposes. Many more states offer breaks for at least a portion of what retirees get from pension payments. 

Tax rates for singles

If you're not married and don't qualify for other filing statuses, you have to use the following table for single filers.

Taxable income

Tax is this amount plus this tax rate

Applied to the amount over

$0 to $9,525

$0 plus 10%

$0

$9,526 to $38,700

$952.50 plus 12%

$9,525

$38,701 to $82,500

$4,453.50 plus 22%

$38,700

$82,501 to $157,500

$14,089.50 plus 24%

$82,500

$157,501 to $200,000

$32,089.50 plus 32%

$157,500

$200,001 to $500,000

$45,689.50 plus 35%

$200,000

Above $500,000

$150,689.50 plus 37%

$500,000

Data source: IRS.

To see how this works, let's take a simple example. Say you have $100,000 in taxable income after adding up all your income and then accounting for any deductions that you're entitled to take. In that case, you'd go up to the $82,500 to $157,500 line above, which says your tax is $14,089.50 plus 24% of the amount by which your income exceeds $82,500. And $100,000 minus $82,500 is $17,500, so you'd take 24% of $17,500 and get $4,200. Add $4,200 to $14,089.50, and your final tax would be $18,289.50.

Tax rates for heads of households

Qualifying single people who have a child, parent, or other relative whom they support and who lives with them more than half the year can claim head of household status. The levels of taxable income are wider for the head of household brackets than for regular single brackets, making head of household more desirable and leading to less in total taxes owed.

Taxable income

Tax is this amount plus this tax rate

Applied to the amount over

$0 to $13,600

$0 plus 10%

$0

$13,601 to $51,850

$1,360 plus 12%

$13,600

$51,851 to $82,500

$5,944 plus 22%

$51,850

$82,501 to $157,500

$12,698 plus 24%

$82,500

$157,501 to $200,000

$30,698 plus 32%

$157,500

$200,001 to $500,000

$44,298 plus 35%

$200,000

Above $500,000

$149,298 plus 37%

$500,000

Data source: IRS.

Tax rates for joint filers

If you're married and file jointly, the following tax rates apply. This table also applies to widows and widowers whose spouses died within the past couple of tax years.

Taxable income

Tax is this amount plus this tax rate

Applied to the amount over

$0 to $19,050

$0 plus 10%

$0

$19,051 to $77,400

$1,905 plus 12%

$19,050

$77,401 to $165,000

$8,907 plus 22%

$77,400

$165,001 to $315,000

$28,179 plus 24%

$165,000

$315,001 to $400,000

$64,179 plus 32%

$315,000

$400,001 to $600,000

$91,379 plus 35%

$400,000

Above $600,000

$161,379 plus 37%

$600,000

Data source: IRS.

Tax rates for married people filing separately

If you're married but choose to file separately, the income levels at which various tax rates apply are half as much as for joint filers. In all but the highest brackets, this table is the same as for single filers.

Taxable income

Tax is this amount plus this tax rate

Applied to the amount over

$0 to $9,525

$0 plus 10%

$0

$9,526 to $38,700

$952.50 plus 12%

$9,525

$38,701 to $82,500

$4,453.50 plus 22%

$38,700

$82,501 to $157,500

$14,089.50 plus 24%

$82,500

$157,501 to $200,000

$32,089.50 plus 32%

$157,500

$200,001 to $300,000

$45,689.50 plus 35%

$200,000

Above $300,000

$80,689.50 plus 37%

$300,000

Data source: IRS.

How to estimate adjusted gross income and taxable income

It's great to know what all the potential pension tax rates are for various situations, but knowing what to do with all of those numbers can be tricky. Fortunately, it's not difficult to come up with at least a rough estimate of what your taxable income will be.

The first step is to look at what's known as your adjusted gross income. This includes nearly all the income you receive from any source, including work income in the form of salary, bonuses, and tips; investment income such as interest and dividends; income from any rental properties you own; money you get from unemployment or as severance pay; self-employment income you get from working side jobs as an independent contractor or running your own business; taxable distributions from retirement accounts like IRAs and 401(k)s; and most other miscellaneous income. There is a limited number of exceptions, such as tax-free municipal bond interest, college scholarships, life insurance death benefits, and child support or spousal maintenance payments.

Once you've added all those numbers together to get your gross income, you then get to make downward adjustments for certain other items, including deductible IRA and health savings account contributions, student loan interest payments, early withdrawal penalties on bank accounts, and half of any self-employment tax that you have to pay. The result is your adjusted gross income.

Adjusted gross income is just the intermediate step in coming up with the taxable income figure that goes into the tables listed above. You have two choices for further reductions: You can either itemize certain tax deductions, or you can take the standard deduction amounts listed below.

Filing Status

Standard Deduction for 2018 Tax Year

Single

$12,000

Married filing jointly

$24,000

Head of household

$18,000

Married filing separately

$12,000

Source: IRS.

If the standard deduction amount is bigger than what you'd be able to itemize, then you'll want to take the standard deduction. Otherwise, itemizing is the right move.

Once you subtract the standard deduction or itemized deductions from your adjusted gross income, you'll have your taxable income. Taking that number and finding out where on the tax brackets you land will tell you the tax rate that applies to your pension income.

How does my Social Security affect my taxes?

Social Security benefits are an unusual example of income that is sometimes included as gross income and sometimes not included. If your income from all sources is high enough, then you'll be required to include at least a portion of your Social Security benefits as taxable income. That can push your total taxable income higher, and that in turn can push the tax rate that applies to your pension income into the next bracket up.

The following chart gives some basic information on how much of your Social Security can be subject to tax depending on how much qualifying income you have.

Filing Status

50% Taxation Threshold on Social Security

85% Taxation Threshold on Social Security

Single, head of household, qualifying widow(er)

$25,000

$34,000

Married filing jointly

$32,000

$44,000

Source: IRS.

It's important to understand that the elements that go into calculating the qualifying income numbers in the table are different from the adjusted gross income and taxable income figures that we've seen thus far. To start out, you'll need to take all the gross income you get from regular taxable sources, including job income, investment income, and taxable distributions from retirement accounts. Then, add in one-half of your total Social Security benefits for the year. If the resulting amount is larger than the number in the middle column above for your filing status, then you could have to include up to 50% of your Social Security income as taxable income. If the amount exceeds the number in the right column, then up to 85% of your Social Security benefits can become taxable.

The exact amount varies greatly depending on your particular situation, but this Social Security tax calculator will give you a much more precise read on how your Social Security benefits could end up affecting your pension tax situation.

Some common examples

It's easier to understand how these provisions work by applying them to some simple examples. First, let's look at a single retiree whose sole income in retirement consists of $1,500 a month in Social Security and a pension payment of another $1,250 a month.

To come up with adjusted gross income, you first need to know how much, if any, of the Social Security income will be subject to tax. When you take the $1,250 in taxable pension income and add one-half of the $1,500 monthly Social Security benefit (or $750), you get $2,000 per month, or $24,000 for the year. That's less than the $25,000 threshold for Social Security taxation, so none of the Social Security benefits will be subject to tax.

That leaves a taxable pension adding up to $15,000 as the sole income. If there are no adjustments, then adjusted gross income will also be $15,000. The single person will be able to deduct $12,000 as a standard deduction, leaving $3,000 to get taxed. The rate is 10%, so estimated tax will be $300. Because that's less than $1,000, you won't need to have any tax withheld from your pension, instead just paying the $300 when you file your return.

At the other end of the spectrum, consider a wealthy married couple who share annual taxable investment income of $30,000 and take retirement account withdrawals of another $60,000. They get a total of $4,000 a month in Social Security, and one spouse gets another $2,500 in monthly pension income. For them, income levels are high enough that the maximum 85% amount of Social Security is likely to get taxed, adding $3,400 per month in taxable income. When you take the $90,000 in annual investment income and retirement account withdrawals and add in the pension and taxable Social Security income, you get an adjusted gross income of $160,800. If this couple takes the $24,000 standard deduction, taxable income will be $136,800. That works out to an expected tax of $21,975 using the tables above. In order to have enough money withheld to cover the full amount, the spouse getting the pension will have to ask to have more than $1,800 withheld from each of the $2,500 monthly payments.

When do I need to change my pension tax withholding?

The big challenge with pension tax withholding is that the amount you need to have withheld can change each and every year depending on your taxable income. The following is just a partial list of all the things that can require you to recalculate the correct amount to withhold in order to avoid having too little or too much withheld:

  • A key life change -- including marriage, divorce, or the death of a spouse -- that can result in a change in your filing status and therefore raise or lower the tax rates that apply to your particular income level.
  • Changes in the amount of income you get from other sources, such as when you leave your job or your spouse does the same; if rates of return on investments rise or fall; or you make different choices with respect to tapping IRAs, 401(k)s, or similar retirement accounts that have an impact on your resulting taxable income.
  • Major changes in tax laws, such as the tax reform bill passed in late 2017.
  • Changes in the amounts that you're able to claim as itemized deductions that therefore affect how much you're able to reduce your adjusted gross income to get a lower taxable income figure.

Finally, moving to a different state can also have a big impact on your tax situation, because many states impose taxes on pension income in a similar way to how the federal government treats it. States that have income taxes also typically require tax withholding or quarterly estimated tax payments in order to avoid their own state-level penalties as well.

Even if you have the situation with the IRS in hand, it's worth making a call to your state's taxing authority in order to make sure that you've appropriately dealt with any obligations you have at home.

Be smart about pension tax withholding

Having a pension adds a valuable extra piece of financial support to help your retirement be more comfortable and secure. But along with extra income, you'll also have to deal with the extra taxes that result. To avoid underpayment penalties to the IRS, setting up your pension tax withholding to address the income tax bill you'll have to pay on your retirement income will go a long way toward preventing major headaches.

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