Most pension withdrawals are taxed as ordinary income, but the amount you owe depends on how you funded the pension and when you take the money out

When you withdraw money from a pension, the IRS treats it as income for that year. The tax you pay is based on your total income that year and your tax bracket — the same way wages are taxed. However, the rules differ sharply between pensions you funded yourself (with after-tax dollars) and pensions your employer funded (with pre-tax dollars). Understanding which type you have is the first step to knowing what you'll owe.

If your pension was funded entirely by your employer using pre-tax contributions, every dollar you withdraw is taxable. If you contributed your own money to the pension after taxes were already taken out, only the growth and employer contributions are taxed — your original contributions come out tax-free. Most traditional pensions fall into the first category, which means you will owe income tax on the full amount.

Key Takeaways

  • Withdrawals from employer-funded pensions are taxed as ordinary income at your marginal tax rate for the year you withdraw the money.
  • If you contributed your own after-tax money to the pension, that portion returns to you tax-free; only employer contributions and growth are taxed.
  • Withdrawals before age 59½ from most pensions trigger a 10 percent early withdrawal penalty on top of income tax, with narrow exceptions for disability, medical hardship, and certain other situations.
  • You can roll a pension into an IRA or another employer plan to defer taxes and potentially reduce your tax bracket in retirement.
  • Your pension provider will withhold federal income tax automatically unless you elect otherwise, but withholding is not the same as paying your full tax bill.

How pension income is taxed in your retirement year

When you receive a pension payment, it counts as income on your tax return for that year. The IRS taxes it at your marginal tax rate — the rate that applies to your highest dollar of income. If you have other income that year (Social Security, investment gains, part-time work), your pension pushes you into a higher bracket, and you may owe more tax on the pension itself.

For example, if you are single and earn $50,000 from a pension in 2024, your federal tax on that pension depends on what other income you have. If the pension is your only income, you fall into the 12 percent bracket (for income between $11,600 and $47,150). If you also have $30,000 in Social Security and $20,000 in investment income, your total is $100,000, and the pension portion is taxed at the 22 percent bracket instead.

Your pension provider will send you a 1099-R form in January showing how much you withdrew and how much federal tax was withheld. This is not your final tax bill — it is only what was set aside. You may owe more when you file your return, or you may receive a refund if too much was withheld.

The difference between pre-tax and after-tax pension contributions

If you contributed money to your pension before taxes were taken out (a pre-tax contribution), that money was never taxed when you earned it. When you withdraw it, the full amount is taxable income. This is true for most traditional pensions, 401(k)s, and similar employer plans.

If you made after-tax contributions — meaning you paid income tax on the money when you earned it — that portion is not taxed again when you withdraw it. Only the employer's contributions and any investment growth are taxable. To track this, the IRS uses the pro-rata rule. If your pension is 70 percent employer-funded and 30 percent your after-tax contributions, then 30 percent of every withdrawal comes out tax-free and 70 percent is taxable.

You will need to know your basis (the total after-tax contributions you made over the years) to calculate this correctly. Your pension provider should have this information, but if you are unsure, request a statement showing contributions by source.

Early withdrawal penalties and exceptions

If you withdraw from a pension before age 59½, you owe a 10 percent early withdrawal penalty on top of regular income tax. This penalty applies to the taxable portion of the withdrawal. For example, a $10,000 withdrawal at age 55 would trigger $1,000 in penalty tax plus your ordinary income tax on the $10,000.

Several situations exempt you from the penalty, though not from income tax. You can withdraw without penalty if you are disabled, if you have unreimbursed medical expenses above 7.5 percent of your adjusted gross income, if you are a public safety officer killed or disabled in the line of duty, or if you are taking substantially equal periodic payments (a specific calculation that locks you into regular withdrawals for five years or until age 59½, whichever is longer). Some pensions also allow penalty-free withdrawals for financial hardship, but the rules vary by plan.

If you leave your job and your pension is in a 401(k) or similar plan, you can roll it into an IRA without triggering the penalty. This does not avoid taxes — it defers them — but it gives you more control over when and how much you withdraw.

Withholding versus your actual tax bill

Your pension provider withholds federal income tax automatically from each payment. The amount withheld is based on a W-4P form you complete when you start receiving payments. You can choose to have no tax withheld, a flat amount withheld, or a percentage withheld.

Withholding is not payment of your tax bill — it is money set aside on your behalf. If you have other income, your pension withholding may not be enough to cover what you actually owe. If your pension is your only income and you have no other deductions, withholding may be more than you need, and you will receive a refund.

You can adjust your withholding at any time by submitting a new W-4P to your pension provider. If you expect to owe more tax than will be withheld, you can increase the amount, or you can make quarterly estimated tax payments yourself. If you expect a refund, you can reduce withholding to keep more money in your pocket during the year.

State and local taxes on pension income

Federal income tax is only part of the picture. Most states also tax pension income, though the rules vary widely. Some states exempt pension income entirely. Others tax it like any other income. A few states tax only pensions from out-of-state employers, or only pensions from private employers (not government pensions).

If you live in a state with income tax and receive a pension from an employer in another state, you may owe tax to both states. Some states offer credits to avoid double taxation, but you will need to file returns in both places. If you are considering moving in retirement, state tax treatment of pensions is worth researching — the difference can be thousands of dollars per year.

Your pension provider will not withhold state or local tax unless you request it. You are responsible for paying what you owe, either through withholding or by making quarterly estimated payments to your state.

Rolling over a pension to reduce your tax burden

If you leave a job and have a pension in a 401(k), 403(b), or similar plan, you can roll it into a traditional IRA without triggering taxes or penalties. This does not reduce your total tax bill over time — you will still owe tax when you withdraw — but it can help you manage your tax bracket in any given year.

With an IRA, you control when you withdraw money. If you have a high-income year, you can take less from the IRA and stay in a lower bracket. If you have a low-income year, you can take more. This flexibility can save you money if you are strategic about it. You can also convert part of a traditional IRA to a Roth IRA in a low-income year, pay tax on the conversion at a lower rate, and then withdraw from the Roth tax-free later.

A rollover must be completed within 60 days of receiving the money, or it is treated as a withdrawal and becomes taxable. The safest method is a direct rollover, where your pension provider sends the money directly to the IRA custodian. You never touch the money, so there is no 60-day clock and no withholding.

Frequently Asked Questions

Do I have to pay taxes on my entire pension, or just part of it?

If your employer funded the pension entirely with pre-tax money, you pay tax on the full amount. If you made after-tax contributions, that portion comes out tax-free. Your pension provider can tell you what portion, if any, is your after-tax basis.

What happens if my pension provider withholds too much tax?

You will receive a refund when you file your tax return. If you expect this to happen, you can reduce your withholding on your W-4P form to keep more money during the year instead of waiting for a refund.

Can I avoid the 10 percent early withdrawal penalty?

Yes, if you are disabled, have high medical expenses, are taking substantially equal periodic payments, or meet other narrow exceptions. You can also roll the pension into an IRA, which does not trigger the penalty. However, you will still owe income tax on the withdrawal.

Will my pension push me into a higher tax bracket?

It depends on your other income. If your pension is your only income, it determines your bracket. If you have other income, your pension is added on top, and the combination determines your bracket. This is why some retirees owe more tax than they expect.

Do I owe state tax on my pension?

Most states tax pension income, but the rules vary. Some states exempt pensions entirely, while others tax them like wages. Check your state's tax website or contact your state revenue department to learn what applies to you.