Taxation of Pension Income: Federal, State, and Penalties

The taxation of pension income starts with a simple federal rule: if your employer funded the plan or you contributed pre-tax dollars, every dollar you receive in retirement is taxed as ordinary income at the same graduated rates that apply to wages.¹ Whether you also owe state tax depends entirely on where you live. And the biggest surprises for retirees usually aren’t the pension tax itself but the way pension income drags Social Security into taxable range and lifts Medicare premiums two years later.

How the Federal Government Taxes Your Pension

For 2026, ordinary income rates run from 10 percent to 37 percent depending on your total taxable income. Pension income gets no preferential rate. You report it on lines 5a and 5b of Form 1040: line 5a shows the total distribution, line 5b shows the taxable portion.² For most retirees whose plans were entirely pre-tax, those two numbers match.

The standard deduction for 2026 is $16,100 for single filers and $32,200 for married couples filing jointly. If you’re 65 or older, you get an additional $2,050 as a single filer, or $1,650 per qualifying spouse on a joint return. That age-based bump is one of the few tax breaks built specifically for retirees.

When Part of Your Pension Is Tax-Free

If you contributed after-tax dollars during your working years, you already paid tax on that money once. A portion of each monthly payment is treated as a tax-free return of that original investment, and only the remainder counts as taxable income.³

For pensions from qualified employer plans that started after November 18, 1996, you use the Simplified Method.⁴ Divide your total after-tax contributions by a number of expected payments based on your age when payments began:

Age 55 or under: 360 expected payments
Age 56 to 60: 310 expected payments
Age 61 to 65: 260 expected payments
Age 66 to 70: 210 expected payments
Age 71 or older: 160 expected payments

If you contributed $52,000 in after-tax dollars and started your pension at age 63, you’d divide $52,000 by 260 to get $200 per month that is tax-free. The rest of each payment is taxable. Once you’ve recovered your full after-tax investment, every subsequent payment becomes fully taxable.⁴

A separate calculation called the General Rule applies to pensions from nonqualified plans, such as commercial annuities or private arrangements, and to qualified plan recipients age 75 or older on the annuity starting date whose payments are guaranteed for at least five years.⁴ It uses IRS actuarial tables rather than the fixed-age table above.

The 10 Percent Penalty on Early Withdrawals

Taking money from a pension before age 59½ triggers a 10 percent additional tax on top of regular income tax, applied to the taxable portion of the distribution.³ Several exceptions can save you the penalty:

Separation from service during or after the calendar year you turn 55, for distributions from that employer’s plan.
Total and permanent disability.
Substantially equal periodic payments (SEPP) set up based on your life expectancy.
Unreimbursed medical expenses that exceed the deduction threshold.
Payments to a former spouse under a qualified domestic relations order.
Distributions to an employee certified by a physician as terminally ill.

The SEPP option is the one people use most often when they retire early and need income before 59½. You choose one of three IRS-approved calculation methods (required minimum distribution, fixed amortization, or fixed annuitization) and commit to the schedule.⁵ Modify the payments before you reach 59½ or before five years have passed, whichever is later, and the IRS retroactively imposes the 10 percent penalty on every distribution you took under the arrangement, plus interest. You also can’t add money to the account or take extra payments. Most SEPP arrangements that fail do so because people treated them as flexible.

Required Minimum Distributions

The IRS won’t let you defer pension taxes forever. Once you reach a certain age, you have to start withdrawing a minimum amount each year, and those withdrawals are taxable. Under current law, the required beginning age is 73 for anyone born between 1951 and 1959. That rises to 75 starting in 2033.⁶

Your first required minimum distribution must be taken by April 1 of the year after you turn 73. If 2026 is the year you turn 73, you can delay your first RMD until April 1, 2027. But you’ll also owe a second RMD by December 31, 2027. Doubling up like that can push you into a higher tax bracket, lift your Medicare premiums, and make more of your Social Security taxable. Taking the first distribution on time is usually the better move.

One exception: if you’re still working and don’t own 5 percent or more of the company sponsoring the plan, you can delay RMDs from that employer’s plan until you actually retire.⁶ The “still working” exception doesn’t apply to IRAs or to plans from previous employers.

Missing an RMD is expensive. The excise tax is 25 percent of the amount you should have withdrawn. If you correct the shortfall within two years, the penalty drops to 10 percent.⁷ You report the missed amount on Form 5329.

Lump Sum or Monthly Payments

Some retirees can take the entire pension balance in a single payment instead of monthly checks. The tax consequences are immediate and significant.

When a lump-sum distribution from a qualified plan is paid directly to you, the plan administrator must withhold 20 percent for federal taxes before sending the check. That withholding is mandatory even if you intend to roll the money into an IRA within 60 days.⁸ The 20 percent default may not cover your actual tax bill depending on your bracket, and you can request additional withholding using Form W-4R.⁹

To avoid immediate taxation entirely, you can roll the distribution into a traditional IRA or another qualified plan within 60 days of receiving the funds.¹⁰ Here’s the catch: since 20 percent was already withheld, you need to come up with that amount from other funds to roll over the full distribution. If you only roll over what you actually received, the withheld 20 percent is treated as a taxable distribution.

A direct rollover, where the plan sends the money straight to your new IRA custodian without you touching it, avoids both the 20 percent withholding and the 60-day clock. If you’re not planning to spend the money right away, that’s almost always the better route.

How Pension Income Raises Your Other Tax Bills

The tax on the pension itself is only part of the story. Pension income flows into calculations that determine how much of your Social Security is taxable, what you pay for Medicare, and whether your investment income gets a surtax. This is where retirees lose the most money through poor planning.

Social Security Taxation

Whether your Social Security benefits are taxable depends on your “combined income,” which is your adjusted gross income (pension included) plus any nontaxable interest plus half of your Social Security benefits. The thresholds, set in 1983 and never indexed to inflation, are low:¹¹

Single filers with combined income below $25,000: Social Security is not taxed.
Single filers between $25,000 and $34,000: Up to 50 percent of benefits become taxable.
Single filers above $34,000: Up to 85 percent of benefits become taxable.
Joint filers below $32,000: Social Security is not taxed.
Joint filers between $32,000 and $44,000: Up to 50 percent of benefits become taxable.
Joint filers above $44,000: Up to 85 percent of benefits become taxable.

A married couple receiving $30,000 in pension income and $25,000 in Social Security has a combined income of $42,500. That puts them in the 50 percent tier. Even a modest pension can push Social Security benefits into the taxable range.

Medicare Premium Surcharges

Medicare Part B and Part D premiums go up for higher-income retirees through the Income-Related Monthly Adjustment Amount, or IRMAA. The surcharge is based on your modified adjusted gross income from two years earlier, so your 2024 return determines your 2026 premiums. Pension income counts. For 2026, the IRMAA brackets are:¹²

Individual income up to $109,000 (joint up to $218,000): No surcharge.
Individual $109,001 to $137,000 (joint $218,001 to $274,000): $81.20 per month for Part B, plus $14.50 for Part D.
Individual $137,001 to $171,000 (joint $274,001 to $342,000): $202.90 per month for Part B, plus $37.50 for Part D.
Individual $171,001 to $205,000 (joint $342,001 to $410,000): $324.60 per month for Part B, plus $60.40 for Part D.
Individual $205,001 to $499,999 (joint $410,001 to $749,999): $446.30 per month for Part B, plus $83.30 for Part D.
Individual $500,000 or more (joint $750,000 or more): $487.00 per month for Part B, plus $91.00 for Part D.

At the top tier, IRMAA adds nearly $7,000 per year in extra premiums per person. A retiree who takes a large lump-sum distribution, or who doubles up an RMD, can spike income for a single year and pay elevated premiums two years later. The two-year lag makes the cost invisible at the time of the decision.

Net Investment Income Tax

Pension distributions themselves aren’t subject to the 3.8 percent Net Investment Income Tax. But pension income counts toward the modified adjusted gross income that determines whether your other investment income (dividends, capital gains, interest) crosses the NIIT threshold: $200,000 for single filers, $250,000 for joint filers.¹³ A retiree with a $70,000 pension and $160,000 in investment income has a MAGI of $230,000. The pension isn’t taxed at 3.8 percent, but it pushed $30,000 of investment income above the threshold, adding $1,140 in tax.

How States Tax Pension Income

State tax treatment varies enormously, and the differences can add up to thousands of dollars per year. Most states with an income tax start with your federal adjusted gross income and then apply their own adjustments for retirement income.

Partial exemptions are the most common approach. Some states exempt a fixed dollar amount of pension income regardless of the recipient’s total earnings. Others tie the exemption to age, increasing the tax-free threshold once you reach 60, 62, or 65. Distinctions based on the source of the pension are widespread: military retirees and government employees often receive broader exemptions than private-sector retirees, and in some states a government pension is fully tax-free while private pension income is fully taxable. Many states phase out pension exemptions at higher income levels, so a retiree earning $40,000 may qualify for a full exemption while someone earning $100,000 sees the benefit reduced or eliminated.

States That Don’t Tax Pension Income

Nine states impose no broad-based personal income tax, so pension income goes untaxed at the state level: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Washington does impose a separate tax on capital gains from investments, but that tax doesn’t apply to pension distributions or other retirement income.

A separate group of states keeps an income tax but specifically exempts pension distributions. Illinois, Mississippi, and Pennsylvania are among the most notable, fully excluding qualifying pension income while still taxing interest, dividends, or business earnings. Several additional states offer full exemptions with age or income qualifications.

The distinction between no income tax and a pension-specific exemption matters when you look at the full picture. A state that exempts pensions but taxes investment income treats you differently than one with no income tax at all, especially if you have significant savings outside your pension. Property taxes, sales taxes, and estate taxes vary as well and can offset any income tax advantage.

Moving to a Different State in Retirement

Federal law protects you when you earn a pension in one state and retire in another. Under 4 U.S.C. § 114, no state may tax the retirement income of someone who isn’t a resident of that state.¹⁴ If you worked your entire career in a high-tax state and then moved to a no-tax state at retirement, your former employer’s state can’t reach back to tax your pension payments.

The protection covers distributions from most qualified plans, including 401(a) trusts, 403(b) annuities, 457 deferred compensation plans, IRAs, and government plans, as long as the payments are part of a series of substantially equal periodic payments over your life expectancy or for at least 10 years.¹⁴ Military retired pay is also covered regardless of how it’s structured. Lump-sum distributions and certain nonqualified plan payouts may not qualify. The form of the payment matters.

Withholding, Reporting, and Estimated Tax

Your pension administrator handles federal withholding based on the instructions you provide on Form W-4P, which covers periodic (monthly or quarterly) payments.¹⁵ It works much like the W-4 you filled out as an employee: you provide filing status and adjust withholding to match your expected total income. Nonperiodic distributions, such as a partial withdrawal, use Form W-4R instead.⁹

At year end you receive Form 1099-R, which reports the gross distribution, the taxable amount, and a code identifying the type of distribution.¹⁶ Those numbers transfer to lines 5a and 5b of Form 1040. The IRS receives a copy of your 1099-R directly from the plan administrator and cross-references it against your return, so the numbers need to match.

If pension withholding doesn’t cover your full tax bill (because of investment income, Social Security taxation, or state taxes), you may need quarterly estimated tax payments. The IRS charges an underpayment penalty if you owe more than $1,000 at filing time and haven’t paid at least 90 percent of your current-year tax or 100 percent of your prior-year tax through withholding and estimated payments. If your adjusted gross income exceeds $150,000, the prior-year safe harbor rises to 110 percent.¹⁷

A practical alternative to mailing quarterly checks: increase your withholding on Form W-4P to cover the expected gap. Pension withholding is treated the same as wage withholding for estimated tax purposes and is considered paid evenly throughout the year, which simplifies the math.

Special Situations

Divorce

When a court divides a pension in a divorce through a qualified domestic relations order, or QDRO, the tax liability follows the money. A former spouse who receives payments under a QDRO reports that income on their own return as if they were the plan participant.¹⁸ If the distribution goes to a child or other dependent instead, it’s taxed to the plan participant, not the child. A QDRO distribution to a former spouse is exempt from the 10 percent early withdrawal penalty even if the recipient is under 59½.³

Disability Retirement

If you retire early because of a disability, the tax treatment depends on your age and the source of the payments. Before you reach the age at which you would have normally retired, disability pension payments are reported as wages on line 1 of Form 1040. Once you reach the plan’s normal retirement age, the payments shift to pension income on lines 5a and 5b.¹⁹

Military and certain government disability payments get more favorable treatment. If the disability resulted from combat, extra-hazardous service, or conditions simulating war, the payments can be excluded from income entirely. Veterans who would qualify for VA disability compensation can also exclude an equivalent amount, even if they never formally applied for VA benefits.¹⁹

Inherited Pensions

When a pension participant dies, the surviving spouse or beneficiary who receives ongoing payments generally owes income tax on those payments under the same rules that applied to the original participant.²⁰ A surviving spouse has the most flexibility: they can typically roll the inherited pension into their own IRA, delay distributions, and manage the tax impact over time. Non-spouse beneficiaries face more restrictive distribution timelines and generally can’t roll the funds into their own retirement account.

Foreign Pensions

If you’re a U.S. resident receiving a pension from a foreign employer, the payments are generally taxable even though you won’t receive a Form 1099-R. The taxable amount is calculated the same way as a domestic pension: gross distribution minus your after-tax investment in the plan.²¹ You may be able to claim a foreign tax credit for taxes the other country withheld, which prevents double taxation. Most tax treaties include a saving clause that preserves the U.S. right to tax its citizens and residents on worldwide income, so treaty benefits for foreign pensions are limited. The specific rules depend on the treaty with each country, and professional help is worth the cost here.

1
Office of the Law Revision Counsel. 26 USC 402 – Taxability of Beneficiary of Employees Trust
2
Internal Revenue Service. Instructions for Form 1040
3
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
4
Internal Revenue Service. Publication 575 – Pension and Annuity Income
5
Internal Revenue Service. Substantially Equal Periodic Payments
6
Office of the Law Revision Counsel. 26 USC 401 – Qualified Pension, Profit-Sharing, and Stock Bonus Plans
7
Internal Revenue Service. Retirement Plan and IRA Required Minimum Distributions FAQs
8
Internal Revenue Service. Topic No. 412, Lump-Sum Distributions
9
Internal Revenue Service. About Form W-4R, Withholding Certificate for Nonperiodic Payments and Eligible Rollover Distributions
10
Internal Revenue Service. Rollovers of Retirement Plan and IRA Distributions
11
Office of the Law Revision Counsel. 26 USC 86 – Social Security and Tier 1 Railroad Retirement Benefits
12
Centers for Medicare & Medicaid Services. 2026 Medicare Parts A and B Premiums and Deductibles
13
Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
14
Office of the Law Revision Counsel. 4 USC 114 – Limitation on State Income Taxation of Certain Pension Income
15
Internal Revenue Service. About Form W-4P, Withholding Certificate for Periodic Pension or Annuity Payments
16
Internal Revenue Service. Form 1099-R – Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, Etc.
17
Internal Revenue Service. Underpayment of Estimated Tax by Individuals Penalty
18
Internal Revenue Service. Retirement Topics – QDRO: Qualified Domestic Relations Order
19
Internal Revenue Service. Publication 525 – Taxable and Nontaxable Income
20
Internal Revenue Service. Topic No. 410, Pensions and Annuities
21
Internal Revenue Service. The Taxation of Foreign Pension and Annuity Distributions