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Pension Taxes and Retirement Checks - Are Pension Checks Taxable?

written by: Patricia Tokar, CPA•edited by: Laurie Patsalides•updated: 7/30/2010

Planning for the types of taxes that are paid for a retirement check or a pension check is an important part of budgeting for retirement. While most taxes paid for a retirement check are straightforward, there is a hidden tax that might hit you hard, so read on to learn how to dodge it

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    Types of Retirement Checks

    The types of taxes that are paid for a retirement check will depend on what type of retirement check or pension check you are receiving. Here are some of the common types of retirement checks and pension checks that may be taxable:

    * Regular pension or 401(k)

    * Regular pension or 403(b) from a government-type employer

    * Social Security or Social Security Equivalent of RailRoad Retirement Benefits (RRB)

    * Individual Retirement Account (IRA, ROTH IRA, SIMPLE IRA)

    * Other types of retirement income, such as an annuity, a Keogh Plan, or an unqualified employer plan

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    Federal Income Taxes Paid For a Retirement Check

    Your retirement check is subject to income taxes, but it is not subject to social security taxes, medicare tax withholding, or unemployment taxes.

    Virtually all retirement checks are classified as ordinary income. Retirement checks in general are not capital gain income. There are some circumstances where some of your check might be classified as capital gain income. This applies mostly to those born before 1936 and taking their retirement benefits in a lump-sum distribution.

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    How Much of Your Pension Check is Taxable

    Just because all of your retirement check is subject to income taxes does not mean it is all taxable. If you contributed any of your own funds on a post-tax basis to your own retirement fund, such as an IRA, or to your employer's pension fund, or 401(k) fund, then a proportionate portion will be withdrawn tax free, even if you are making an early withdrawal. In general, you will compare your after-tax contributions to the total value of your retirement fund and calculate a percentage. This percentage will then be the portion of each check that is not taxable. Most retirement and pension administrators will report this taxable dollar amount to you on your yearly tax forms.

    A ROTH IRA withdrawal may even be tax free. If the ROTH IRA was established five or more years earlier and the withdrawal is made after age 59-1/2, then none of the retirement check should be taxable.

    For regular pension checks, most annuity withdrawals, and many government pensions, the taxable portion will usually be calculated for you. Simply look in Box 2a of your yearly 1099-R for the taxable portion of your retirement checks. If the box 2a is blank, then you will need to calculate the taxable portion yourself, using either the General Rule or the Simplified Method if your retirement checks started after 7-1-86. See the Form 1040 instructions for the Simplified Method or see IRS Publication 939 for the General Method. These methods both use your own contributions and the total pension to get a ratio to determine the non-taxable portion. Once established, these ratios tend to stay somewhat constant over the years.

    Social Security and RRB Equivalent income will only become taxable when your other income reaches certain limits. A very rough estimate to use for this is to add 1/2 of your Social Security (or Equivalent) income plus all of your other taxable income. If the sum is over $32,000 (joint) or $25,000 (single), then up to 85% of your benefits may be taxable.

    Also keep in mind that most funds that are timely or directly rolled over into another qualified retirement account are not taxed.

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    Taking an Early Withdrawal

    The IRS defines an early withdrawal as taking a check from your retirement fund before age 59-1/2. The penalty for taking an early withdrawal is 10% (up to 25% for certain SIMPLE IRA withdrawals) of the taxable portion of your retirement check. There are exceptions to the penalty, including setting up the withdrawal as an annuity, being a first time homebuyer, qualifying medical expenses, paying for health insurance while unemployed, withdrawing due to disability or death. See IRS Publication 590 for more details.

    Keep in mind that this early withdrawal penalty tax is in addition to any income taxes and may be payable regardless of the amount of your tax credits, itemized deductions and personal exemptions.

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    The Hidden Tax Paid For a Retirement Check

    If you are receiving both Social Security income plus other retirement benefits, then be cautious of this tax. Refer to the rough rule above regarding taxable Social Security benefits. If your taxable income is high enough, you will begin paying tax on your Social Security benefits. This "hidden tax" can reach a point where every extra dollar of retirement income can create nearly a dollar of taxable Social Security income. This extra taxable income tends to come as an unpleasant surprise when you make a larger than usual IRA withdrawal which now makes your income high enough to create taxable Social Security income. Often, this extra tax can be avoided or reduced simply by straddling your extra IRA withdrawal over two years. You may even benefit by bunching several years of extra withdrawals into one year and just paying the tax on Social Security benefits once instead of each year. It pays to run the calculations to determine the best approach to extra retirement withdrawals.

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    State Taxes

    The majority of states have limited or no tax on Social Security benefits. About half of the states that impose individual income taxes have a preferred treatment for other retirement earnings.

    Many retirement administrators do not withhold State taxes from your checks. If not, you may need to make State estimated tax payments.

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    Conclusion

    A little planning can go a long way when it comes to budgeting for retirement. Yes, most pension checks are taxable. Knowing in advance what types of taxes are paid for a retirement check, a pension check, or other retirement savings withdrawals can be key to a stress-free and abundant retirement income.

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    Legal Section

    This article is not intended to be specific tax advice. It is intended as a general guideline only. Any specific advice should be sought from your tax professional.

    CIRCULAR 230 DISCLOSURE: Pursuant to Treasury Department guidelines, any federal tax information contained in this article, or any attachment, does not constitute a formal tax opinion. Accordingly, any federal tax advice contained in this communication, or any attachment, is not intended or written to be used, and cannot be used, by you or any other recipient for the purpose of avoiding penalties