Most pensions are taxable as ordinary income, but the amount you owe depends on how you funded the pension and whether you've already paid tax on those contributions

A pension is taxable income in the year you receive it, just like wages. The IRS treats it as ordinary income, which means it's taxed at your regular income tax rate — not at the lower capital gains rate. However, the portion of your pension that comes from your own after-tax contributions is not taxed again. Only the employer's contributions and any investment earnings are subject to income tax.

The key distinction is between may have access to pensions (employer-sponsored plans like traditional 401(k)s and defined-benefit pensions) and non-may have access to pensions (less common arrangements). Most people receive may have access to pensions, where the tax treatment is straightforward: you pay income tax on distributions, and the IRS requires you to start taking distributions at age 73 (as of 2023, under current rules).

Key Takeaways

  • Pension distributions are taxed as ordinary income at your regular tax rate, not as capital gains.
  • The portion of your pension funded by your own after-tax contributions is not taxed a second time.
  • You must report all pension income on your federal tax return, and most states tax pension income as well.
  • Some military pensions and federal employee pensions receive special tax treatment under specific circumstances.
  • You can request tax withholding from your pension check to avoid owing a large amount at tax time.

How the IRS separates taxable and non-taxable pension portions

If you contributed your own money to a pension plan before taxes were taken out, that portion comes back to you tax-free. The IRS calls this your basis — the amount you already paid tax on. Everything else in your pension is taxable.

To calculate your basis, you need to know how much of your own money went into the plan over the years. If you have records of contributions you made with after-tax dollars, keep them. The pension plan administrator can also provide a statement showing your basis, though you may need to request it specifically. Once you know your basis, you can calculate what percentage of each payment is non-taxable.

For example, if your total contributions were $50,000 and your pension will pay you $200,000 total over your lifetime, then 25 percent of each payment is non-taxable. The remaining 75 percent is subject to income tax. This calculation is called the exclusion ratio, and you use it every year you receive pension payments.

Withholding taxes from your pension check

When you start receiving pension payments, the plan administrator will ask you to complete a W-4P form (Withholding Certificate for Pension or Annuity Payments). This form tells the plan how much federal income tax to withhold from each payment. You can choose to have no tax withheld, a flat dollar amount withheld, or a percentage withheld.

Many people choose to have taxes withheld so they don't face a large tax bill in April. The amount you request is deducted from your pension payment before you receive it. If you don't request withholding and you owe taxes, you may also owe estimated tax penalties if you didn't pay enough throughout the year.

You can change your withholding at any time by submitting a new W-4P to your plan administrator. If your tax situation changes — for example, you start receiving Social Security or you have other income — you should review your withholding to make sure it's still correct.

State income tax on pensions

Most states tax pension income the same way the federal government does. However, some states offer partial or full exemptions for certain types of pensions. Military pensions, for instance, are fully exempt from state income tax in many states. Federal employee pensions may also receive special treatment depending on where you live.

A few states — including Illinois, Mississippi, and Pennsylvania — exempt all or most pension income from state income tax, regardless of the source. If you're receiving a pension and considering moving to a different state, the state tax treatment of your pension income can be a significant factor in your decision. You can find your state's specific rules through your state tax authority's website.

Required minimum distributions and taxes

If you have a traditional pension or 401(k), the IRS requires you to begin taking distributions by April 1 of the year after you turn 73 (this age changed from 72 in 2023 under the find 2.0 Act). These are called required minimum distributions, or RMDs. The amount is calculated based on your age and the balance in your account, and you must take it whether you need the money or not.

Every dollar of your RMD that exceeds your basis is taxable income. If you don't take your RMD, the IRS charges a penalty equal to 25 percent of the amount you should have withdrawn (reduced to 10 percent under certain conditions). This is one of the steepest penalties in the tax code, so it's important to track your RMD requirement each year.

Special rules for military and federal employee pensions

Military pensions receive preferential tax treatment in some circumstances. If you served before 1984 and your pension is based on the old military retirement system, you may be able to exclude part of your pension from taxable income. You report this on Form 1040 using Schedule 1.

Federal employees who retired under the Civil Service Retirement System (CSRS) can exclude a portion of their pension equal to their own contributions. This is different from the general rule and can result in a smaller tax bill. Federal employees under the Federal Employees Retirement System (FERS) follow the standard pension taxation rules.

If you receive a pension from the Railroad Retirement Board instead of Social Security, different rules explore to how much is taxable. The same is true for certain government pensions if you also receive Social Security. These situations are complex, and it's worth consulting a tax professional to understand your specific situation.

Pension income and Social Security taxation

Pension income can affect how much of your Social Security benefit is taxable. The IRS uses a calculation called combined income that includes your adjusted gross income, non-taxable interest, and half of your Social Security benefits. If your combined income exceeds certain thresholds, up to 85 percent of your Social Security becomes taxable.

This means that receiving a pension can push you into a higher tax bracket not just on the pension itself, but also on your Social Security. When you're planning your retirement income, it's worth modeling how pension distributions will interact with Social Security to understand your total tax liability.

Frequently Asked Questions

Do I have to pay taxes on my entire pension payment?

No. The portion of your pension that comes from your own after-tax contributions is not taxed again. Only the employer's contributions and investment earnings are taxable. You calculate this using your exclusion ratio, which is the percentage of each payment that represents your own contributions.

What happens if I don't request tax withholding from my pension?

You'll owe income tax on your pension when you file your return. If you don't pay enough tax throughout the year — either through withholding or estimated tax payments — you may owe penalties in addition to the tax itself. You can request withholding at any time by submitting a new W-4P form.

Can I avoid taxes on my pension by rolling it into an IRA?

A rollover doesn't avoid taxes; it defers them. When you roll a traditional pension into a traditional IRA, the money remains tax-deferred until you withdraw it. You'll still owe income tax on distributions, and you'll still be subject to required minimum distributions starting at age 73.

Are military pensions taxed differently?

Military pensions are fully exempt from federal income tax if you served before 1984 under the old retirement system. If you served after 1984, your military pension is taxed like any other pension. However, many states exempt military pensions from state income tax regardless of when you served.

How do I report pension income on my tax return?

You report pension income on Form 1040 using the lines for pensions and annuities. Your pension plan will send you a Form 1099-R showing the total distribution and the taxable amount. If you have a basis in your pension, you may need to file Form 4972 or use a worksheet to calculate the non-taxable portion.