How to Avoid Paying Taxes on Pensions

A retirement saver who expects to receive income from a pension generally needs to account for income taxes in their retirement plan. Most pension benefits are subject to federal income tax and many states also levy taxes on pension income. Retirees may be able to reduce their overall tax burden by taking lump sum distributions and then rolling the cash into tax-advantaged retirement plans. Choosing to retire in a state that doesn’t tax pension income is a way to avoid state income taxes on pension benefits.

A financial advisor can help you create a retirement plan that addresses your income sources and tax liability in retirement. 

Understanding Pensions and Taxes

Pensions are retirement plans offered by employers that provide regular cash payments for life to former employees after they leave the workforce. These payments are generally considered taxable income by the IRS, with the amount of tax owed depending on the type of pension plan and the retiree’s overall income. Pension payments may also be subject to state taxes, though many states offer partial or full exemptions for pension income.

Most pension payments are fully taxable at the federal level because the employer funded the plan with pre-tax dollars, meaning the money was never taxed when it was earned. Therefore, when a retiree starts receiving the payments, the IRS treats the income as taxable.

Some pension benefits may not be taxable under specific conditions. For example, some states don’t tax government pension benefits. And if contributions were made to the pension plan using after-tax dollars, the IRS considers only the earnings on those contributions as taxable.

How to Reduce Taxes on Pensions

Although you may not be able to completely avoid paying taxes on your pension, there are several strategies you can use to reduce the taxes you owe on your pension payouts. Here are some approaches to consider:

• Pension payout distribution options: The way you choose to receive your pension payments can affect how much tax you owe. Retirees can typically choose between receiving a lump-sum payment or monthly payments. Each option comes with different tax implications. Monthly payments are treated as regular income and taxed at your ordinary income tax rate, while lump-sum payouts may be taxed differently based on how you handle the distribution.

• Tax treatment of pension distributions: If your pension contributions were made with after-tax dollars, the portion of your pension that represents your contributions is not taxable. Only the earnings on those contributions will be subject to taxes.

• Lump sum pension distributions: Some retirees choose to take their pension as a lump-sum distribution, which may offer tax advantages in certain situations. For example, rolling the lump-sum distribution into an IRA can allow you to defer paying taxes until you begin withdrawing from the IRA. But, you should note that lump sum distributions often come with a mandatory 20% withholding, which can affect how much money actually gets rolled over.

• State tax exemptions: If you’re moving to a new state in retirement, it may be worth considering a state with more favorable tax treatment for pensions. For example, nine states have no state income tax, and many others offer at least partial exemptions for pension income.

Frequently Asked Questions About Pension Taxes

Is My Pension Subject to Federal Income Tax?

Yes, most pensions are subject to federal income tax. However, if you made contributions to your pension with after-tax dollars, only the earnings on those contributions will be taxable.

Are There Any Pensions That Are Not Taxable?

Certain government pensions, such as those for military personnel or certain public service employees, may be exempt from state taxes in some states. Additionally, if your contributions to the pension were made with after-tax dollars, the portion representing your contributions may not be taxable at the federal level.

Can I Avoid Paying Taxes on a Lump-Sum Pension Payment?

You can defer taxes on a lump-sum pension payment by rolling it into a traditional IRA. This allows the funds to grow tax-deferred, and you only pay taxes when you withdraw money from the IRA. However, if you cash out the lump sum without rolling it into another retirement account, the entire amount will be taxable.

Do I Have to Pay State Taxes on My Pension?

State tax treatment of pensions varies. Some states fully tax pension income, while others tax part or none. Check the laws in your state to determine whether your pension income is subject to state taxes.

Bottom Line

While avoiding taxes on pensions may not be entirely possible, there are several strategies that can help retirees reduce their tax burden. By considering your payout options, understanding the tax treatment of pension distributions and taking advantage of state tax exemptions, you can minimize the taxes you owe on your pension income. Working with a financial advisor or tax professional can also help you identify the best approach to managing your pension taxes in retirement.

Tips for Retirement Planning

• A financial advisor can work with you to create a personalized retirement plan that covers costs of living, healthcare and other expenses. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

• If you want to know how much your retirement savings could grow over time, SmartAsset’s retirement calculator could help you get an estimate.

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