CARL WATTS & ASSOCIATES
November 30, 2015
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Washington DC
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tel/fax 202 350-9002 |
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As with all important changes in people’s lives, retirement may mean different things to different people. If age is the factor to consider, although there is no mandatory retirement age in the United States, standard retirement age is considered to be 65 and retirement before the age of 60 would be an “early” retirement.
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For most people, retirement is possible when they have sources of income that do not have to be earned by working. In other words, the factor to consider for retirement implies financial independence achieved with enough savings, investment income, and/or pension income to cover your living expenses.
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Since we have already touched the subject of Social Security benefits in a previous newsletter, in this one we will cover some of the most relevant facts about taxation of pensions and annuities (other than Social Security). |
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The IRS defines pension in general as a series of definitely determinable payments made to you after you retire from work. Pension payments are made regularly and are based on such factors as years of service and prior compensation.
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An annuity is defined as a series of payments under a contract made at regular intervals over a period of more than one full year. They can be either fixed (under which you receive a definite amount) or variable (not fixed). You can buy the contract alone or with the help of your employer. Examples of annuities are regular deposits to a savings account, monthly home mortgage payments, monthly insurance payments and pension payments.
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If you receive retirement benefits in the form of pension or annuity payments from a qualified employer retirement plan, all or some portion of the amounts you receive may be taxable. |
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As you know, qualified retirement plans are simply those plans that meet the requirements set out in Section 401(a) of the U.S. tax code. |
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A qualified employee plan is an employer's stock bonus, pension, or profit-sharing plan that is for the exclusive benefit of employees or their beneficiaries and that meets Internal Revenue Code requirements. It qualifies for special tax benefits, such as tax deferral for employer contributions and capital gain treatment or the 10-year tax option for lump-sum distributions (if participants qualify). To determine whether your plan is a qualified plan, check with your employer or the plan administrator. |
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A qualified employee annuity is a retirement annuity purchased by an employer for an employee under a plan that meets Internal Revenue Code requirements.
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The majority of retirement savings programs offered by employers are qualified plans since contributions are tax-deductible. There are several types of qualified plans and, of course, some are more common than others.
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The most common type is the defined-contribution plan, which means that the employer and/or employee contribute a set amount to the employee's individual account and the total account balance depends on the amount of those contributions and the rate at which the account accrues interest. Depending on the plan, the employer may not be required to contribute at all and the accrual of funds depends on how much the employee chooses to contribute.
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For the most part, these plans are tax-deferred, meaning contributions are made with pre-tax dollars, and the employee pays income taxes on funds in the year they are withdrawn. |
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If you are self-employed, you have many of the same options of retirement plans on a tax-deferred basis as employees participating in company plans. |
| The pension or annuity payments that you receive are fully taxable if you have no investment in the contract due to any of the following situations: |
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| If you contributed after-tax dollars to your pension or annuity, your pension payments are partially taxable. |
Taxation of Pensions and
Annuities
Annuities
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| You will not pay tax on the part of the payment that represents a return of the after-tax amount you paid. This amount is your investment in the contract, and includes the amounts your employer contributed that were taxable to you when contributed. |
| You figure the tax on partly taxable pensions by using either the General Rule or the Simplified Method. If the starting date of your pension or annuity payments is after November 18, 1996, you generally must use the Simplified Method to determine how much of your annuity payment is taxable and how much is tax-free. |
| If you began receiving annuity payments from a qualified retirement plan after July 1, 1986 and before November 19, 1996, you generally could have chosen to use either the Simplified Method or the General Rule to figure the tax-free part of the payments. |
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| If you receive annuity payments from a non-qualified retirement plan, you must use the General Rule. Under the General Rule, you figure the taxable and tax-free parts of your annuity payments using life expectancy tables prescribed by the IRS. For a fee, the IRS will figure the tax-free part of your annuity payments for you. |
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| If you receive pension or annuity payments before age 59 1/2, you may be subject to an additional 10% tax on early distributions, unless the distribution qualifies for an exception. |
The additional tax does not apply to any part of a distribution that is tax-free or to any of the following types of distributions:
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| The taxable part of your pension or annuity payments is generally subject to federal income tax withholding. |
| You may be able to choose not to have income tax withheld from your pension or annuity payments (unless they are eligible rollover distributions) or may want to specify how much tax is withheld. If so, provide the payer Form W-4P, Withholding Certificate for Pension or Annuity Payments, or a similar form provided by the payer. |
| If you are a U.S. citizen or resident alien and you do not provide the payer a home address in the United States or its possessions. |
| Payers generally figure the withholding from periodic payments of a pension or annuity the same way as for salaries and wages. If you do not submit the withholding certificate, the payer must withhold tax as if you were married and claiming three withholding allowances. Even if you submit a Form W-4P and elect a lower amount, if you do not provide the payer with your correct Social Security number, tax will be withheld as if you were single and claiming no withholding allowances. |
| If you pay your taxes through withholding and the withheld tax is not enough, you may also need to make estimated tax payments to ensure you do not underpay taxes during the tax year. |
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Special rules apply to certain non-periodic payments from qualified retirement plans.
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| If you receive an eligible rollover distribution, the payer must withhold 20% of it, even if you intend to roll it over later. You can avoid this withholding by choosing the direct rollover option. A distribution sent to you in the form of a check payable to the receiving plan or IRA is not subject to withholding. For obvious reasons, your retirement financial situation, complex or less so, will definitely benefit when you enroll help from a tax or financial advisor, as with all your dealings with the IRS. As they say, money may not be better in retirement, but the hours are! |