The Sad Truth: Pensions, Social Security & The IRS


In addition to the usual suspects, like groceries, utilities and car insurance, your fixed income will also have to handle new and unexpected expenses. The transition can be challenging, so planning in advance is important. Of course, any accurate plan must include taxes. Your employer might be giving you a much-deserved break, but in times like these, Uncle Sam probably won’t. So if you want to avoid a fiscal crisis of your own, don’t forget to include taxes in your budget.

To figure out how much of a crimp the IRS will put into your retirement lifestyle, you’ll need to know how social security, pensions, annuities and other retirement plans are treated. Daily Deduction regulars know that distributions from a traditional IRA or 401(k) are generally taxable, while distributions from a Roth IRA or Roth 401(k) usually aren’t. Also, your investment income, like interest from CD’s or dividends from stock, will still be taxed as usual. But what about the other kinds of income that retirees depend on? We have the scoop on pension benefits, annuities, and social security benefits just for you.

Pension Benefits. In most cases, pension payments are taxable. That’s because most employers who save money on their employees’ behalf don’t withhold any taxes. Instead, employers make contributions to a tax-free pension fund where they remain invested until they’re paid to retired employees. Because pension fund payments that you receive in retirement are made in exchange for work that you did while you were employed, the IRS treats them as though they were wages. As a result, you can expect your pension plan administrator to withhold taxes for you, just like your employer did with your paychecks. Paying taxes on a fixed budget can be a real drag, but there is one bright spot: since your income is usually lower in retirement, your tax rate will be lower too.

Annuity Payments. Did you invest in an annuity to help fund your retirement? If so, you can expect to receive regular payments when you retire, and a portion of each payment will be taxable. Think of your annuity as though it were a CD. When you cash out a CD, only the interest is taxed. The money that you used to purchase it is not. Because you’ve already paid tax on that money once, there is no need to pay again. An annuity is similar. When you receive payments, a portion of each one is a return of your original investment, which won’t be taxed. For example, if you purchase an annuity for $9,000, and it pays you $1,000 every year for ten years, you’ll receive $10,000 overall, but only $1,000 of that amount will be taxed. Each year, when you receive your $1,000 payment, $900 will be a tax-free return of your investment, and $100 will be taxable income. Of course, the math for a real annuity may be more complicated, and your insurer can guide you through it.

Social Security Benefits. Ah, social security. The government giveth and the government taketh away. Many people assume (rationally), that because social security payments come from the government, they aren’t taxed. After all, why would the government give you money, and then spend even more money to take back what it gave to you? Frankly, the system doesn’t make a whole lot of sense. But, indeed, most people pay tax on their social security benefits.

To determine whether your benefits will be taxed, divide them in half and add the rest of your income, including income from tax-exempt bonds. If you file a joint return with your spouse and the result of your calculation is more than $32,000, some of your social security benefits will be taxed. The threshold is lower if you’re single; a result of $25,000 or more will mean that some of your benefits will be on the chopping block. On the flip side, if you fall below these benchmarks, your benefits won’t be taxed at all.

Once you’ve determined that some of your benefits are taxable, you’ll have to figure out which portion the IRS can reach, and which portion it can’t. If you’re single, and your earlier calculation gave you between $25,000 and $34,000, you’ll have to include up to 50% of your social security benefits on your Form 1040. If your calculation gave you $34,000 or more, you may have to include up to 85% of your social security benefits on your Form 1040. If you’re filing with your spouse, the limits are more generous. If the result of your calculation was less than $44,000, you’ll have to include up to 50% of your benefits, and if it was $44,000 or more, you may have to include up to 85%. Of course, these are just ballpark figures. To figure out exactly what portion of your social security benefits will be taxed, you’ll have to use a special worksheet found in the Form 1040 instructions. Finally, the tax rate on your social security benefits will be the same rate that applies to the rest of your income. The more income you have, the higher the rate will be.

Of course, no one knows how long Congress will keep the current laws and rates, so it’s impossible to make a perfect plan in advance. But don’t let that stop you from getting a rough retirement budget onto paper. A little bit of work now could really pay off in the long run.

For more tax info, check out our complete archive of Daily Deductions.

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