Taxation of Pensions

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on January 22, 2024

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Definition of Taxation of Pensions

Taxation of pensions refers to the process of levying taxes on the income received by an individual from their pension plan, including any withdrawals or distributions made from the plan.

This can include federal and state income taxes, as well as potential penalties for early withdrawals or failure to take required minimum distributions.

Pensions serve as a crucial source of income for many retirees. Understanding the taxation of pensions is essential to making informed decisions about retirement planning.

Types of Pension Plans

Pension plans come in different forms, each with unique characteristics and tax treatments. The primary types of pension plans include:

Defined Benefit Plans

Defined benefit plans, also known as traditional pensions, provide a predetermined amount of monthly income to retirees based on factors such as years of service and salary history. Employers bear the investment risk and are responsible for funding the plan.

Defined Contribution Plans

In defined contribution plans, such as 401(k)s and 403(b)s, employees and employers contribute to individual accounts. The retirement income depends on the account balance and investment performance. Employees typically bear the investment risk.

Hybrid Plans

Hybrid plans, such as cash balance plans, combine elements of both defined benefit and defined contribution plans. These plans usually offer a guaranteed rate of return, with the employer bearing the investment risk.

Individual Retirement Accounts (IRAs)

IRAs are personal retirement savings vehicles that offer tax advantages. They come in various forms, including traditional IRAs, Roth IRAs, and rollover IRAs. Each type has specific tax implications.

Types of Pension Plans

Taxation of Pension Contributions

The taxation of pension contributions depends on the source of the contributions and whether they are made with pre-tax or after-tax dollars.

Employer Contributions

Employer contributions to pension plans are generally tax-deductible for the employer and not considered taxable income for the employee. However, these contributions may be subject to payroll taxes, such as Social Security and Medicare taxes.

Employee Contributions

Employee contributions to pension plans can be either pre-tax or after-tax, depending on the plan's structure.

Pre-tax contributions reduce taxable income for the year, while after-tax contributions do not. Employees aged 50 and older can also make catch-up contributions, allowing them to contribute additional amounts above the standard limit.

Taxation of Pension Distributions

The taxation of pension distributions depends on several factors, including the type of pension plan, the recipient's age, and their tax bracket.

Taxation of Distributions From Defined Benefit Plans

Distributions from defined benefit plans are generally taxable as ordinary income. However, if an employee made after-tax contributions to the plan, a portion of each distribution may be tax-free.

Taxation of Distributions From Defined Contribution Plans

Distributions from defined contribution plans, such as 401(k)s, are typically taxed as ordinary income. Qualified distributions from Roth 401(k)s and Roth IRAs, however, are tax-free, provided certain conditions are met.

Taxation of Distributions From Hybrid Plans

Hybrid plans, like cash balance plans, generally follow the same taxation rules as defined benefit plans, with distributions taxed as ordinary income.

Taxation of Distributions From IRAs

Traditional IRA distributions are usually taxed as ordinary income, while qualified Roth IRA distributions are tax-free. In some cases, early IRA distributions may be subject to an additional 10% penalty.

Rollovers and Transfers

Rollovers allow individuals to move retirement assets between eligible plans without triggering immediate taxation.

Rollover Rules for Pensions

Rollover rules vary depending on the type of pension plan involved. Generally, rollovers must occur within 60 days to avoid taxation.

Direct and Indirect Rollovers

Direct rollovers occur when funds are transferred directly between plan administrators. Indirect rollovers involve the individual receiving a distribution and then depositing the funds into another eligible plan within 60 days.

Tax Implications of Rollovers

When executed correctly, rollovers are not subject to immediate taxation.

However, if an individual fails to complete an indirect rollover within the 60-day window or does not meet other rollover requirements, the distribution may be treated as taxable income and potentially subject to a 10% early withdrawal penalty.

Transfers Between Pension Plans

Transfers between pension plans, such as moving assets from one IRA to another, do not trigger taxation when done correctly. It is crucial to follow the plan's specific transfer rules to avoid unintended tax consequences.

Early Withdrawals and Penalties

Withdrawing funds from a pension plan before reaching the eligible retirement age can result in additional taxes and penalties.

Definition of Early Withdrawal

An early withdrawal occurs when an individual takes money out of a pension plan before reaching the age of 59½, which is generally the minimum age to avoid penalties.

Early Withdrawal Penalties

Early withdrawals from pension plans are typically subject to a 10% penalty in addition to regular income taxes. However, there are exceptions to this rule.

Exceptions to Early Withdrawal Penalties

Some circumstances allow for penalty-free early withdrawals, such as purchasing a first home, higher education expenses, or facing a significant financial hardship. It is essential to consult a tax professional to determine eligibility for these exceptions.

Required Minimum Distributions (RMDs)

RMDs are the minimum amounts that must be withdrawn from certain retirement accounts each year to avoid substantial tax penalties.

Definition of RMDs

Required Minimum Distributions are mandatory annual withdrawals from qualified retirement accounts, such as traditional IRAs and 401(k) plans, starting at age 73 (or age 70½ for those who reached that age before January 1, 2020).

Calculating RMDs

RMD amounts are based on the account balance and the account holder's life expectancy, as determined by IRS-provided life expectancy tables.

RMD Deadlines

RMDs must be taken by December 31 each year, except for the first RMD, which can be delayed until April 1 of the year following the year the account holder turns 73 (or 70½ for those who reached that age before January 1, 2020).

Tax Implications of RMDs

RMDs are generally taxed as ordinary income, with the exception of distributions from Roth IRAs and Roth 401(k)s, which are not subject to RMDs.

Pension Taxation for Expatriates and Non-residents

Pension taxation can vary for individuals living outside the United States or non-resident aliens.

Taxation of Pensions for US Citizens Living Abroad

U.S. citizens living abroad are still subject to U.S. income tax on their worldwide income, including pension distributions. However, they may qualify for certain tax credits, deductions, or exclusions to offset foreign taxes paid.

Taxation of Pensions for Non-resident Aliens

Non-resident aliens may be subject to U.S. tax withholding on pension distributions from U.S. sources. The withholding tax may be reduced or eliminated under certain tax treaties between the U.S. and the individual's country of residence.

Tax Treaties and Their Impact on Pension Taxation

Tax treaties between the U.S. and other countries can affect pension taxation, potentially reducing or eliminating taxes for qualifying individuals. It is essential to consult a tax professional or review the applicable tax treaty to understand its implications.

Pension Tax Planning Strategies

Proactive tax planning can help pension holders maximize their retirement income and minimize taxes.

Consideration of Tax Brackets

Understanding current and future tax brackets can help individuals make informed decisions about when to take distributions and how much to withdraw

Timing of Pension Distributions

Strategically timing pension distributions can have a significant impact on taxes. For example, taking distributions during years with lower taxable income can help minimize taxes owed.

Roth IRA Conversions

Roth IRA conversions from traditional IRA or 401(k) assets can provide tax-free income in retirement. Although taxes must be paid on the conversion amount, future qualified distributions will be tax-free. This strategy may be beneficial for individuals who expect higher tax rates in the future.

Charitable Giving

Donating a portion of retirement assets to a qualified charity can help reduce taxable income while supporting a meaningful cause.

In some cases, individuals can make a qualified charitable distribution (QCD) directly from their IRA, which can help satisfy RMD requirements and avoid taxation on the distribution.


Understanding the complex rules surrounding pension taxation is essential for effective retirement planning. Various factors, such as the type of pension plan, contributions, distributions, rollovers, and early withdrawals, can all impact an individual's tax liability.

Additionally, expatriates and non-residents face unique challenges when it comes to pension taxation.

Strategies like careful timing of distributions, Roth IRA conversions, and charitable giving can help optimize tax outcomes for pension holders.

As tax laws are subject to change, it is recommended to stay informed about the latest developments and consult a tax professional to navigate the complexities of pension taxation effectively.

Taxation of Pensions FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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