Regardless of whether you’ve been saving for retirement for years or just starting out, there may be some tax strategies that you may not be aware of. You may have heard from your financial advisor or from your co-workers that you should contribute to a Retirement or Pension Plan. Before you contribute to a Tax Deferred Retirement Plan, or Withdraw from it, Learn How Pension Income is Taxed.
What is a Pension?
A pension is a retirement plan sponsored by an employer. Some plans, such as 401k plans, allow you to make contributions to the account, but you don’t have to.
The employer contributes a pool of money that gets paid out to eligible employees. In order to receive this pension payout, employees must be vested in the company. Most companies require you to give them at least six years of your service or of retiring age.
What Is an Annuity?
An annuity is a type of insurance that you pay into for in exchange for guaranteed income for the rest of your life. Sometimes annuities are immediate, which means the premiums you pay each month can quickly become income right away if needed.
If you don’t, you can defer your defined benefit plan to pay your income at a later time in your life. The funds you defer can follow an index, go into an investment, or can earn a fixed interest.
Are My Annuities and Pensions Taxable?
The Internal Revenue Service states that a part of your annuity or pension contributions are taxable if you made those contributions with after-tax dollars. You don’t pay taxes on the portions that represent a return of the after-tax amount paid in. These contributions include amounts that your employer may have contributed that were taxable as your income.
Any contributions you make to the plan with after-tax income, the ones you did not take a deduction for, are not taxable when your plan distributes. These include contributions made by an employer on your behalf but were considered income, so you claimed them on your tax return and paid taxes on them.
Simplified Method vs. General Rule
There are two ways for you to determine how much of your annuities amount will be taxed. Those two ways are the simplified method or the general rule.
If your annuity started between July 1, 1986, and November 18, 1996, you have to use the General Rule. You also have to use the General Rule if the starting date of your annuity was after November 18, 1996, your payments were guaranteed for five years, and you were already 75 years old or older. If you’ve received payments from a nonqualified plan, you too are restricted to only being able to use the General Rule.
The Simplified Method
If you weren’t over the age of 75 with a guaranteed plan after November 18, 1996, you could use the Simplified Method to determine how much of your annuity is taxed and which is not. You can use the Internal Revenue Service’s Simplified Method Worksheet to help you through the process.
The General Rule
The General Rule method requires you to use the life expectancy tables provided by the IRS to figure out what portion of your payments are tax-free and what you must pay taxes on. You can check out their Publication 939 to see how to calculate these two amounts.
Account Types and Taxes
Not all retirement accounts are taxed the same as the other. If you take out any withdrawals from Roth 401(k) plans or from a Roth IRA, you don’t have to pay any taxes. Any after-tax contributions enable you to receive your funds free of any taxes as long as you’ve had the account for a minimum of five years.
Any tax-deferred accounts, such as SEP IRAs, 401(k), 457, 403(b)s, and any self-directed traditional IRAs, come with taxes. The funds are subject to income taxes when you take out any withdrawals from your traditional retirement account.
Traditional Account Distributions
It is important to note that once you turn 72, you must take out withdrawals from your traditional retirement accounts. If you don’t take out the required withdrawals, the IRS imposes a 50% excise tax on the money you were supposed to take out. If you have a Roth IRA, there are no required withdrawals. Instead, distributions come after death.
Social Security Benefits Tax
So what about your social security benefits? Unlike pensions and IRAs, you don’t pay the standard income tax as you do on those accounts.
Instead, the amount that is taxable depends on your provisional income. To figure out how much you need to pay in taxes on your SSI benefits, you can use the IRS Publication 915 Worksheet 1.
As a general rule of thumb, if your provisional income is less than $25,000, you don’t have to pay any taxes. If you file jointly with your spouse and you receive less than $32,000, you also don’t have to pay any taxes on that provisional income.
Taxable Social Security Benefits
On the other hand, if your provisional income falls between $25,000 and $34,000 as a single filer, half of your benefits are taxable. Anything between $32,000 to $44,000 for joint filers carries the same tax burden as the single filer.
How to Save Money on Retirement Taxes
There are several different tax strategies that you can take to reduce your retirement tax liability. For example, if you have a 401(k), make contributions. When you contribute to a traditional 401(k), you can defer paying income tax on your retirement savings until the money is withdrawn from the account.
In 2022, workers are allowed to defer taxes on up to $20,500 of their contributions to the 401(k). This also applies to Thrift Savings Plan and a 403(b). As mentioned earlier, if you make these contributions via your payroll deduction, you almost immediately get a tax break.
If you use an IRA to save for retirement, you can defer up to $6,000 in income taxes. Even though you can defer that money, you may not be able to claim the tax deduction if you also have a 401(k) through an employer and earn more than a certain amount.
In 2022, the IRA tax deduction phased out in 2022 for those who had a 401(k) account and made between $68,000 to $78,000. For married couples, if they both had a 401(k) and jointly made $109,000 to $129,000, the deduction was phased out. If only one of the two had a 401(k), the tax break phase-out caps at an income of $204,000 to $214,000.
Workers over the age of 50 can receive an additional tax break if they make what is called a “catch-up contribution” to their retirement account. This tax break is only available for those over the age of 50, and they have the opportunity to contribute an additional $6,500 towards their 401(k) plan.
This means that they can contribute as much as $27,000 in 2022. If you are over 50 and you also have an IRA, you can contribute an additional catch-up contribution to the IRA of $1000.
Did you know that if you contribute to an IRA or 401(k) each year, you are eligible for something called a saver’s credit? You have the opportunity to claim this credit on contributions of up to $2,000 and is worth between 10% to 50% of whatever amount contributed.
Saver’s credit thresholds per tax filing status:
- Individual (single filers): $34,000
- Heads of households: $51,000
- Married couples: $68,000
The great thing about this credit is you can claim it in addition to the tax deduction you get for a traditional retirement account contribution. If you are a married couple, you can claim an additional $4,000 instead of the $2,000.
Delay Withdrawing from Your 401(K)
If you are still working, you may want to avoid taking out money from your retirement accounts. If you stay employed well into your 70s and don’t own 5% or more of a company-sponsored retirement account, you may be able to delay withdrawing from your 401(k) account until you retire from work.
However, it is essential to note that the required minimum distribution rule still applies if you are over the age of 72 and you have accounts associated with previous employment. If you have another account from a previous job, make sure to take out the required distribution to avoid that hefty 50% tax.
Diversify Your Accounts
If you wish to avoid paying significant taxes in retirement, you may want to diversify your accounts. This includes having both a traditional IRA and a Roth account.
Of course, everyone’s financial situation is different, so what may work for one person may not work best for you. In order to see what will work best for you, you may want to reach out to a tax professional for a free consultation and to get more guidance.
Should I Hire a Tax Advisor
Planning for your retirement, especially if you aren’t sure what you are looking for or what to deduct, can be a difficult task. Fortunately, there are excellent tax advisors and attorneys who can help you with your retirement planning so that you get the most out of your money.
Although these people are excellent resources, it may be hard to find the right one for you. It would be best if you looked out for a few things when picking your tax advisor.
Check Out Their Reviews
Regardless if you received the recommendation of a tax advisor from a close friend or a reliable family member, you would want to do your own due diligence. For starters, if you have a few professionals in mind, take a look at their reviews and see what other clients experienced when working with them.
Make sure to look at the company reviews posted on websites where the business cannot alter or change the statements sent in. For example, you can check out the Better Business Bureau or Google.
Review Their Qualifications
Handling your retirement is a huge deal, so you won’t want to leave the job to someone who has no idea what they are talking about. All reputable tax professionals with experience in retirement planning have the proper designations needed to do their job.
Reach Out to Them Personally
As mentioned earlier, you can take a look at their online reviews to gauge how others felt about working with them, but the only way to know if they are a good fit for you is to see for yourself. Several different tax professionals offer free no-obligation consultations. During the consultation, feel them out and feel free to ask any questions or concerns you may have about the process.
How Can I Reach Out to You?
When you partner with a reputable tax professional, you will want to be able to reach them in the event of an audit or if you have any questions. Your advisor should be able to clearly explain what they are helping you with, and they should be available to answer any questions or concerns you may have about the process.
How Do I Report Annuity and Pension Income?
To ensure that you correctly report your pension and annuity income, you will first want to separate any 1099-R statements you’ve received into two main categories. One category is for your IRA, and the other is for your pension and annuities.
On form 1040, you can report your IRA distributions on lines 4a and 4b and any annuity distributions or pension distributions on lines 5a and 5b. Column 5b separates the taxable amount, whereas 5a is the total amount of your distributions.
Regardless of the type of job you have or the amount of money you have saved up, you will want to make sure that you are able to enjoy your retirement income comfortably.
The last thing you want is to do is retire, withdraw your money from your 401(k), and get hit by a large hefty tax you did not see coming.
Now that you learned more about How Pension(Retirement) Income is Taxed, There are several tax strategies available for you to take advantage of that will ensure that you are well taken care of in your retirement age.
If you found this article helpful and want to learn more about different tax strategies available for you and your situation, check out our blog!