How to calculate taxable portion of pension using simplified method

Pensions are an excellent benefit that gives you an income during your retirement years, but there can be tax consequences of which you need to be aware. Whether your entire pension is taxable or only a part of your pension is taxable depends on how your employer sets the account up.

Rules for taxes are different for pensions than for other retirement income. Knowing your tax liability on your pension is an important factor in calculating how much you will receive.

Taxes by Contribution

One factor that determines whether your pension is taxable is how much you contributed pre-tax. In some cases, you might not contribute to your pension at all, but your employer continues to make contributions on your behalf. If your employer made all of the contributions and did not withhold any taxes from them, then the entire amount you receive will be taxable.

In some cases, a portion of your pension will be tax-free and a portion will be taxable. If you contributed after-tax dollars to your pension, you will get credit and this portion will not be taxed because taxes have already been paid. Any earnings that you made on your contributions will be taxed. To calculate your taxable portion, the IRS has developed what is known as the Simplified Method.

Calculating Taxable Portion of Pension

To calculate how much of your pension is taxable and how much taxes you owe, many people can use the Simplified Method Worksheet. This sheet allows you to prorate your contributions toward the pension plan over your expected lifetime. Using this method, you can have a portion of your pension tax-free and you can carry forward any unused tax credits into the following year.

The IRS also has an alternative method called the General Rule that can be used to calculate the amount of taxes you will owe on your pension. When you receive your Form 1099-R, the taxable amount should be shown in Box 2a. If it is not, you might need to consult IRS Publication 575 and Publication 939 to calculate the taxable portion of your pension that should be entered onto your Form 1040.

If your annuity started before ​July 1, 1986​, you might be required to use the Simplified Method to figure the taxable portion of your distribution.

Using the Simplified Method

Certain rules apply to who can use the Simplified Method for the calculation of the taxable portion of your distribution. First, you must be enrolled in a qualified retirement plan. You cannot use the Simplified Method if you are age ​75​ or older. Also, your annuity must be for a specified number of payments to use this method. If your annuity or your age disqualifies you from using the Simplified Method, you must use the General Rule instead.

For calculations using the Simplified Method, the annuity starting date is the first day you begin receiving payments. You need to be aware that there are special rules for survivors and survivor’s benefits. If your annuity is variable, or you do not receive the payments on a regular schedule, then you must use the General Rule and cannot use the Simplified Method. Other rules apply that depend on the type of annuity, all of which are explained in IRS Publication 939.

If you have a pension and other forms of retirement income, or your spouse has additional income, you need to determine which is taxable and which is tax-free. IRS Publication 4190 explains the difference between taxable and non-taxable retirement income. If you have any questions about whether you can use the Simplified Method or how the Simplified Method applies to you, you can contact the IRS or a tax professional for further information.

Tax time can be particularly confusing when you have pension or annuity income. The Internal Revenue Service (IRS) says that some or all of the amounts you receive from these sources can be taxable. How they're taxed depends on various factors. Fortunately, the IRS offers various tools for calculations.

Key Takeaways

• Taxation of pension or annuity income depends on whether you contributed to the plan with before-tax or after-tax dollars. 
• Claiming a tax deduction for contributions makes them taxable upon withdrawal.
• Not claiming a tax deduction at the time you made the contribution makes the income tax-free upon distribution. 
• You must calculate how taxes will be paid by using one of two methods, depending on the starting date of your plan: the general rule or the simplified method.

The Taxable Portion of Your Pensions and Annuities

The IRS says that your payments are partially taxable if you made your contributions to your pension or annuity with after-tax dollars. You won't pay tax on the portion of the payments that represent a return of the after-tax amount you paid in. These contributions represent your cost in the plan or investment. They include amounts that your employer might have contributed that were taxable to you as income at the time they were made.

Any contributions that you made with after-tax income, those for which you never took a tax deduction, aren't taxable to you at the time of distribution. These include contributions your employer made on your behalf but which were attributed to you as income, so you claimed them on your tax returns and paid taxes on the amounts when they were contributed.

The General Rule vs. the Simplified Method

You must determine the method by which the remaining amounts will be taxed. Partly taxable pensions and annuities are taxed under either the General Rule or the Simplified Method.

Note

You must use the General Rule if your annuity or pension payments began on or before November 18, 1996. You can use the Simplified Method to pin down the taxable portion if your pension or annuity payments began after that date.

You're restricted to using the General Rule if the starting date of your annuity was between July 1, 1986, and November 18, 1996, and if you don't qualify to use the Simplified Method.

You must also use the General Rule if your starting date is after November 18, 1996, you were age 75 or older as of that date, and your payments were guaranteed for at least five years.

You're limited to using the General Rule if you've received payments from a nonqualified plan. A qualified retirement plan is a qualified employee plan, a qualified employee annuity, or a tax-sheltered annuity plan.

The General Rule

The General Rule requires that you use the life expectancy or actuarial tables provided by the IRS to figure the taxable and tax-free portions of your payments. They're included in IRS Publication 939, General Rule for Pensions and Annuities. The publication also walks you through the calculations for your taxable pension and annuity under the General Rule.

Note

The IRS will calculate your taxable pension income under the General Rule for you for a nominal fee if you don't want to risk making a mistake.

The easiest, safest option might be to consult a tax professional or have the IRS make these calculations for you.

The Simplified Method

The IRS says you can use the Simplified Method to determine how much of your annuity or pension payments is taxable and how much is tax-free if the starting date of payments was after November 18, 1996. The IRS provides a Simplified Method Worksheet to help you along.

How to Report Pension and Annuity Income

Separate any 1099-R statements you receive into two piles: those from your IRA and those from your pension or annuity plans. You'll report your IRA distributions on lines 4a and 4b of the 2021 Form 1040. Report your pension and annuity distributions on lines 5a and 5b. The 5a column is for your total distributions. The 5b column segregates the taxable amount.

These lines may differ on tax returns on an annual basis. The IRS has revised Form 1040 a number of times since 2017. The appropriate lines can change by tax year. These lines apply to the 2021 tax return you'll file in 2022.

Frequently Asked Questions (FAQs)

What is a pension?

A pension is an employer-sponsored retirement plan. The employer contributes to a pool of money that's paid out to eligible retired employees. Employees can contribute as well to some plans. The pension payout is determined by your pay at the time you retired and your years of service.

What is an annuity?

An annuity is a type of insurance. You pay a premium to an insurance company, and you receive a guaranteed income for the rest of your life. An annuity can be immediate, which means your premium is converted into income right away, or deferred, which means it can be converted into income later. The funds in deferred annuities can earn a fixed interest rate or follow an index, or they can be invested.

How do you calculate taxable pension?

What form is used to calculate the taxable pension using the simplified method?

How do you calculate the taxable portion of an annuity?

What percentage of pension is taxable?