How to avoid paying taxes on pensions

A man is looking for a way to avoid paying taxes on pensions.

A retirement saver who expects to receive retirement income typically must factor income taxes into their retirement plan. Most retirement benefits are subject to federal income tax, and many states also impose taxes on retirement income. Retirees may be able to reduce their overall tax burden by taking a lump sum and then putting the cash into tax-advantaged retirement plans. Choosing to retire in a state that does not tax retirement income is a way to avoid state income taxes on retirement benefits.

AND financial advisor can help you create a retirement plan that takes into account your income sources and tax obligations in retirement.

Understanding Pensions and Taxes

Pensions are retirement plans offered by employers that provide regular cash payments for life to former employees after they leave the workforce. These payments are generally considered taxable income by the IRS, and the amount of tax due depends on the type of pension plan and the retiree’s total income. Pension payments may also be subject to state tax, although many states offer partial or complete exemptions from tax on pension income.

Most retirement payouts are fully taxable at the federal level because the employer funded the plan with pre-tax dollars, meaning the money was never taxed when it was earned. So when a retiree starts receiving the payouts, the IRS treats the income as taxable.

Some retirement benefits may not be taxable under certain circumstances. For example, some states do not tax government retirement benefits. And if you contributed to a retirement plan with after-tax dollars, the IRS considers only the earnings from those contributions taxable.

How to Reduce Taxes on Pensions

While you may not be able to completely avoid paying taxes on your retirement, there are several strategies you can use to reduce the taxes you owe on your retirement distributions. Here are a few approaches to consider:

Pension distribution options: How you choose to receive your retirement payments can affect how much tax you owe. Retirees can typically choose to receive a lump sum payment or monthly payments. Each option has different tax implications. Monthly payments are treated as regular income and taxed at your regular income tax rate, while lump sum payments may be taxed differently depending on how you manage the distribution.
Taxation of pension payments: If your retirement contributions were made with after-tax dollars, the portion of your retirement that represents your contributions is not subject to tax. Only the earnings from those contributions will be subject to tax.
Lump-sum pension payments: Some retirees choose to take their retirement benefits in a lump sum, which can provide tax benefits in certain situations. For example, rolling over a lump sum into an IRA can allow you to defer paying taxes until you start withdrawing from your IRA. However, keep in mind that lump sum withdrawals often come with a mandatory 20% withholding, which can affect how much money you actually roll over.
State tax exemptions: If you’re moving to a new state to retire, it’s worth considering a state with more favorable tax treatment for retirement. For example, nine states have no state income tax, and many more offer at least partial tax exemptions for retirement income.

Pension Tax FAQs

Is my retirement income subject to federal income tax?

Yes, most pensions are subject to federal income tax. However, if you contributed to your pension with after-tax dollars, only the earnings from those contributions will be taxable.

Are there any pensions that are not taxable?

Some government pensions, such as those for military personnel or some public service employees, may be exempt from state taxes in some states. In addition, if your pension contributions were made with after-tax dollars, the portion that represents your contributions may not be subject to federal taxation.

Can I avoid paying taxes on a lump sum pension payment?

You can defer taxes on a lump sum retirement withdrawal by rolling it over to a traditional IRA. That way, the funds grow tax-free and you pay taxes only when you withdraw the money from the IRA. However, if you withdraw the lump sum without rolling it over to another retirement account, the entire amount will be taxable.

Do I have to pay state taxes on my retirement?

State treatment of pensions varies. Some states fully tax pension income, while others tax it partially or not at all. Check the laws in your state to determine whether your pension income is subject to state tax.

Summary

An elderly couple is reviewing their retirement plan.

While it may not be entirely possible to avoid retirement taxes, there are several strategies that can help retirees reduce their tax burden. By considering withdrawal options, understanding the tax treatment of retirement distributions, and taking advantage of state tax exemptions, you can minimize the taxes you owe on your retirement income. Working with a financial advisor or tax professional can also help you identify the best approach to managing retirement taxes in retirement.

Retirement Planning Tips

A financial advisor can work with you to create a personalized retirement plan that includes living expenses, healthcare, and other expenses. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three vetted financial advisors in your area, and you can have a free introductory call with an advisor to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you want to know how much your retirement savings could grow over time, the SmartAsset retirement calculator can help.

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