Pension Income Tax Exemptions: Federal, State, and 1099-R Rules

Pension income tax works like this at the federal level: your monthly pension check is taxed as ordinary income, at the same graduated rates that apply to wages. A portion of each payment escapes tax only if you contributed after-tax dollars to the plan during your working years. On top of that base rule, early withdrawal penalties, required minimum distributions, Social Security interactions, and state-level exemptions all change how much of your pension you actually keep.

How the Federal Tax Applies

Distributions from a qualified employer retirement plan are taxed under 26 U.S.C. § 72 as annuity income at ordinary rates.¹ If your employer funded the entire plan and you never put in after-tax money, every dollar is fully taxable. Most traditional defined-benefit pensions fall into that category, so the full monthly check lands on your return as ordinary income.²

For 2026, those rates run from 10% on the first $12,400 of taxable income for a single filer up to 37% on income above $640,600.³ The 2026 standard deduction is $16,100 for single filers and $32,200 for married couples filing jointly, with an additional amount for taxpayers age 65 and older.

The Tax-Free Slice From Your Own Contributions

If you put after-tax money into the plan, you don’t pay tax on it twice. The IRS calls what you contributed your “cost” or “investment in the contract,” and you recover it tax-free over the life of the annuity. Once you’ve recovered the full amount, every payment after that is fully taxable.⁴

For a qualified employer plan with an annuity starting date after November 18, 1996, you use the Simplified Method. Divide your total after-tax contributions by the number of anticipated monthly payments from a statutory table keyed to your age when payments begin. That result is the tax-free amount you exclude from each check. It stays the same each year even if the payment amount changes.⁴

The General Rule applies instead to annuities from nonqualified plans and to qualified plan annuities that started before November 19, 1996. It uses IRS life expectancy tables to figure the ratio of your investment to expected total return, then applies that ratio to each payment.⁵ The math is harder; the IRS points people to Publication 939 or a private ruling.

Lump Sum or Rollover

Some plans let you take a single lump sum instead of monthly payments for life. Taking the cash triggers immediate tax on the entire taxable portion unless the money moves into another qualified plan or an IRA.

A direct rollover is the clean way. The plan administrator sends the distribution straight to your new IRA or qualified plan, nothing is withheld, and no income is recognized.⁶ If the check comes to you instead, the plan must withhold 20% for federal tax even if you plan to roll it yourself. To defer tax on the full amount, you’d have to make up that 20% out of pocket and deposit the entire original distribution into an IRA within 60 days.⁷

Miss the 60-day window and the full taxable amount becomes ordinary income for the year, which can push you into a higher bracket. The IRS can waive the deadline in limited circumstances beyond your control, but a direct rollover removes the risk entirely.

Early Withdrawal Penalty

Taking money out of a pension or qualified retirement plan before age 59½ generally triggers a 10% additional tax on top of the regular income tax.⁸ On a $50,000 early distribution in the 22% bracket, that comes out to roughly $16,000 in combined tax and penalty. You report the penalty on Form 5329.

Several exceptions cancel the 10% penalty while leaving the ordinary income tax in place:⁹

Separation from service in or after the year you turn 55, from that employer’s qualified plan (age 50 for public safety employees).
A series of substantially equal periodic payments based on life expectancy, taken at least annually.
Total and permanent disability.
Distributions to a beneficiary after the participant’s death.
Unreimbursed medical expenses above 7.5% of adjusted gross income.
Distributions to an alternate payee under a qualified domestic relations order (qualified plans only).
Up to $5,000 per child for a qualified birth or adoption.
Up to $22,000 for a federally declared disaster.
Distributions to an employee certified by a physician as terminally ill.

The age-55 separation exception is the one most people overlook, and it has a trap. It applies only to the plan of the employer you just left. Roll that money into an IRA before taking distributions and the exception is gone.

Required Minimum Distributions

The IRS won’t let you defer tax on retirement money forever. You must begin required minimum distributions at age 73 if you were born between 1951 and 1959, and at age 75 if you were born in 1960 or later.¹⁰

Your first RMD is due by April 1 of the year after you reach the applicable age. Every RMD after that is due by December 31. If you’re still working and don’t own more than 5% of the company, some employer plans let you wait until you actually retire. Pushing the first RMD to the following April means you take two in the same calendar year, which can bump your income into a higher bracket.

The penalty for coming up short is a 25% excise tax on whatever you failed to withdraw.¹¹ That drops to 10% if you fix the shortfall within two years by taking the missed amount and filing an updated return. The rate used to be 50%.

Each year’s RMD is your account balance on December 31 of the prior year divided by a life expectancy factor from the IRS Uniform Lifetime Table. If your sole beneficiary is a spouse more than 10 years younger, a different table produces a smaller required distribution.

How a Pension Affects Social Security Taxes

Pension distributions can pull your Social Security benefits into taxable territory. The IRS uses a “combined income” figure: adjusted gross income, plus any tax-exempt interest, plus half of your Social Security benefits. Pension payments count toward the AGI piece.

For single filers:¹²

Combined income below $25,000: no Social Security is taxed.
$25,000 to $34,000: up to 50% of benefits become taxable.
Above $34,000: up to 85% of benefits become taxable.

For married couples filing jointly, the same thresholds are $32,000 and $44,000. These numbers were set in the 1980s and have never been indexed for inflation, so most retirees with both a pension and Social Security see at least part of their benefits taxed.

Pensions Inherited by Survivors

When a pension participant dies, survivor benefits paid to a spouse or other beneficiary are generally taxable as ordinary income to whoever receives them. The payments are income in respect of a decedent, meaning the beneficiary inherits the tax obligation.¹³ There is no step-up in basis for pension benefits the way there is for inherited stocks or real estate.

A surviving spouse has the most room to maneuver. Many plans let the spouse roll benefits into their own IRA, which defers tax and resets the RMD schedule to the survivor’s age. Non-spouse beneficiaries generally cannot do that and must follow the plan’s rules, which typically require full distribution within 10 years. If the decedent had unrecovered after-tax contributions, the Simplified Method keeps running for the beneficiary.⁴

State Taxes Vary Widely

Federal treatment is only half of it. About a dozen states impose no income tax at all, so pension income passes through untaxed at the state level. Several additional states with an income tax fully exempt pension income from it, bringing the total to roughly 16 states where a pension faces zero state tax.

Many other states offer partial exemptions tied to age, income, or type of pension. Public employee pensions sometimes receive more generous treatment than private ones. A handful of states tax pension income at the same rates as wages with no special exclusion. If you’re weighing where to retire, the difference can amount to thousands of dollars a year, and state rules change often, so check your own state before assuming anything.

Withholding and the 1099-R

Every January, the plan administrator sends you Form 1099-R reporting distributions of $10 or more from the prior year.¹⁴ Box 1 shows the gross distribution, Box 2a shows the taxable amount, and Box 7 carries a distribution code that tells you and the IRS what kind of payment it was. Code 7 is a normal distribution; Code 4 is a death benefit. If the Box 7 code doesn’t reflect an early-withdrawal exception you actually qualify for, you claim it yourself on Form 5329.

You control the federal tax withheld from periodic pension payments by filing Form W-4P with the payer.¹⁵ Too little withholding and you owe a lump sum at filing time, possibly with an underpayment penalty. Too much and you’ve made an interest-free loan to the government. With Social Security, a part-time job, and investment income all in the mix, review your total withholding across every source at least once a year.

For a nonperiodic distribution like a lump-sum payout that isn’t rolled over directly, the plan must withhold 20% for federal tax regardless of what your W-4P says.⁶ That mandatory 20% only applies to eligible rollover distributions. Life annuities and installment schedules of 10 or more years follow the regular W-4P rules instead.

1
Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
2
Internal Revenue Service. Topic No. 410, Pensions and Annuities
3
Internal Revenue Service. IRS Releases Tax Inflation Adjustments for Tax Year 2026
4
Internal Revenue Service. Publication 575, Pension and Annuity Income
5
Internal Revenue Service. Topic No. 411, Pensions – The General Rule and the Simplified Method
6
Internal Revenue Service. Topic No. 413, Rollovers from Retirement Plans
7
Internal Revenue Service. Rollovers of Retirement Plan and IRA Distributions
8
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
9
Internal Revenue Service. Retirement Topics – Exceptions to Tax on Early Distributions
10
Internal Revenue Service. Retirement Topics – Required Minimum Distributions (RMDs)
11
Office of the Law Revision Counsel. 26 USC 4974 – Excise Tax on Certain Accumulations in Qualified Retirement Plans
12
Internal Revenue Service. IRS Reminds Taxpayers Their Social Security Benefits May Be Taxable
13
Internal Revenue Service. Revenue Ruling 2005-30, Section 691 – Recipients of Income in Respect of Decedents
14
Internal Revenue Service. Instructions for Forms 1099-R and 5498
15
Internal Revenue Service. About Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments