Are Defined Benefit Plans Taxable Income?
Defined benefit plan income is typically taxable. This guide explains when you pay taxes on pension payments and the key rules affecting your overall liability.
The taxability of a defined benefit plan depends on the stage of the plan. A defined benefit plan is a traditional pension that provides a specific, predetermined monthly benefit upon retirement, calculated using a formula that considers salary history and years of service. While funds are being contributed and growing, they are not taxed. This includes employer contributions, which are not considered part of your taxable income, and investment earnings, which are not taxed as they accumulate. The tax implications arise when you begin receiving payments in retirement, as these distributions are subject to income tax.
Tax Treatment During the Accumulation Phase
During your working years, a defined benefit plan offers tax advantages. When your employer contributes to the plan, those contributions are not included in your gross income for that year, meaning you do not pay immediate income tax on the money set aside for your retirement. This tax treatment extends to the plan’s investments, which grow on a tax-deferred basis. Any dividends, interest, or capital gains earned by the plan’s investments are not taxed annually, which allows the funds to grow more rapidly than they would in a taxable account.
Taxation of Plan Distributions
When you retire and begin receiving payments from a defined benefit plan, those distributions are considered taxable income. For plans funded entirely by employer contributions, the full amount of each pension payment is subject to federal and state income tax at your ordinary income tax rate. This is because you did not pay tax on the contributions or investment earnings as they accumulated.
A different rule applies if you made after-tax contributions to your pension plan. In this scenario, a portion of each distribution is considered a tax-free return of your “investment in the contract,” also known as your cost basis. Since you have already paid tax on these contributions, they are not taxed again when returned to you. The total amount you can exclude from income is limited to your total after-tax contributions.
To calculate the tax-free portion of each annuity payment, the IRS requires using the Simplified Method for qualified plans. This method involves dividing your cost basis by a number of anticipated monthly payments, which is based on your age as specified in an IRS worksheet. This calculation determines the monthly amount excluded from your taxable income, with the remainder being taxed.
The structure of your payout also affects taxation. If you receive periodic annuity payments, you are taxed on the taxable portion as you receive it each year. Some plans offer a lump-sum distribution, where you receive the entire benefit in one payment. If you take a lump-sum payment and do not roll it over into another retirement account, the entire taxable amount is included in your income for that year, which could push you into a higher tax bracket.
Rules for Special Distribution Scenarios
A rollover allows you to move funds from your defined benefit plan directly to another qualified retirement account, such as a traditional Individual Retirement Arrangement (IRA). A direct rollover is not a taxable event and continues the tax-deferred status of your retirement savings. You will not pay income tax until you withdraw funds from the new account.
Distributions taken before you reach age 59 ½ are considered early distributions and face a tax consequence. In addition to being taxed as ordinary income, the taxable portion of an early distribution is subject to a 10% additional tax penalty. Exceptions to this penalty include distributions due to total and permanent disability, payments to a beneficiary after your death, or distributions made after you separate from service during or after the year you turn 55.
You are required to start taking distributions from your plan once you reach a certain age, even if you are still working. These are known as Required Minimum Distributions (RMDs). The age for beginning RMDs is 73 for individuals born between 1951 and 1959, and for those born in 1960 or later, the RMD age is 75. Failing to take your full RMD by the deadline results in an excise tax of 25% of the amount that should have been withdrawn, reduced to 10% if the mistake is corrected in a timely manner.
Tax Reporting and Withholding
When you receive a distribution, the plan administrator will report the payment to you and the IRS on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form is sent by January 31 of the year following the distribution. You will use the information on this form to report your pension income on your federal tax return on lines 5a and 5b of Form 1040.
Form 1099-R provides details about your distribution. Box 1 shows the total distribution amount you received, Box 2a shows the portion that is taxable income, and Box 4 reports any federal income tax withheld. It is important to review these boxes, as the information is used to calculate your total income and tax liability for the year.
Tax withholding is another aspect of receiving pension distributions. If you receive a lump-sum payment eligible for a rollover but take it directly, the payer is required to withhold a mandatory 20% for federal income taxes. For periodic payments, withholding is voluntary, and you can choose to have tax withheld by filling out Form W-4P, Withholding Certificate for Pension or Annuity Payments. State tax withholding rules on pension payments vary.