Is a pension taxable?

Pensions are often taxable when they are contributed to using pre-tax dollars. In other words, if your employer takes money out of your paycheck before deducting taxes, your taxable income becomes lower making the contribution pre-tax. When the time comes to withdraw from the pension, the income may then be taxed.(1)

• Taxable and partially taxable pensions

In the case of pensions contributed to with after-tax dollars, the amount contributed to the pension plan is tax-free when it is a qualified distribution. Qualified distributions meet specific criteria such as contribution amount which are enforced by tax regulators such as the U.S. Internal Revenue Service.  Overall tax on contributions can be reduced further with the savers credit in some cases. According to the IRS, the savers credit allows an annual tax credit up to $1000 for single tax payers with incomes below set limits who make contributions to applicable pension plans.

Retirement income from Roth IRAs is subject to qualified distributions, but earnings on the post-tax contributions are tax deferred meaning it is taxable upon withdrawal. In other words, since Roth IRA contributions are post-tax, those contributions are generally non-taxable upon withdrawal.  However, a tax penalty of 10% applies to non-qualified pension withdrawals; for example, withdrawals prior to age 59.5 years of age.(1)

• Tax exempt pensions

Some pensions are exempt from taxation; examples of these pensions include Veterans pensions and Railroad worker pensions. Depending on which state one resides in, pension income may or may not be taxable as states are allowed to tax or not tax income independently of the federal government.(2)
• Pension laws and rules

Several laws regulate pensions including the Employee Retirement Income Security Act (ERISA), the Pension Protection Act of 2006 and tax regulations set forth in Title 26 of the U.S. Code.  IRS instructions and rules regarding pension income can be found in IRS Publication 575.

The taxation of pensions can be affected by a number of circumstances and rules; for example rollover of non-qualified pensions to qualified pensions may be taxable prior to rollover or as a condition of rollover. In other words, if a pension contributed to with pre-tax dollars is rolled over into a pension typically contributed to with post-tax dollars, the portion of the pension that was pre-tax will become taxable upon withdrawal.

An important determinant of pension taxation is the cost i.e. the amount contributed to the pension plan by the employee.  As with Roth IRAs, earnings on money put into a retirement plan is generally not exempt from taxation; for example capital appreciation or capital gains. Pension income that is not withdrawn during retirement may be subject to an additional 50% tax if it does not meet the minimum IRS distribution amount.(5) In the case of estate transfer, pension income with a trust fund beneficiary may avoid estate taxes.

• International pension income

International pension income may be taxable in the country of origination and partially exempt from tax in the U.S. depending on the pension type, and specific tax treaty agreement between the countries.(4) The IRS recommends contacting the country's Department of Revenue to clarify how the pension income should be taxed. The IRS also claims that in cases of Social Security Income from other countries, the pension income is typically taxable in the country of origin.  

Sources:

1. http://bit.ly/9L8dVH (Internal Revenue Service)
2. http://bit.ly/jeOTK (Retirement Living)
3. http://bit.ly/cOeBcu (Department of Labor)
4. http://bit.ly/cjPoR6 (IRS: International pensions)
5. http://bit.ly/bJENMf (IRS: Publication 575)

How to rollover a 401(k) into a rollover IRA

Rolling over a 401(k) retirement plan is a process by which assets within an employer 401(k) retirement plan are placed into another account, specifically an Individual Retirement Account (IRA). Since there are variations in 401(k)'s and IRA's, in addition to variance in personal financial circumstances, it is important to realize not all 401(k)'s can be rolled over, or rolled over in the same way.

Image source: Internal Revenue Service

This article will outline key aspects of the 401(k) rollover process, and the steps involved in the 401(k) rollover. Essentially, the rollover of a 401(k) into an IRA can be comprised of 5 steps, each of which have sub-steps within them, those steps are as follows.

Step 1: Determine if the 401(k) is qualified
Step 2: Become aware of rollover options
Step 3: Choose type of rollover and IRA
Step 4: Complete rollover and/or distribution forms
Step 5: Tax reporting

1. Qualified vs Non-Qualified Rollovers

Qualified 401k's can be rolled over into both Roth and Traditional IRA's however Roth 401(k)'s may not be rolled over into a traditional IRA. Thus, the first step in rolling over a 401(k) is to determine if the 401(k) qualifies for the rollover. Some of the rollover options available are listed below and viewable at the following IRS rollover chart:

• 401K to Roth 401(k)
• 401K to SEP-IRA
• 401K to traditional or Roth IRA

Even if the 401(k) is eligible for rollover, certain conditions such as age, amount of rollover, and nationality may apply. For example, if the employee seeking the rollover is above age 59.5 years of age, a distribution may be required by law and the terms of the IRA. Rules for 401(k) rollovers are determined by Title 26 of the US Code and enforced by the Internal Revenue Service. The 401(k) plan itself can also determine the extent and possibility of rollover into an IRA.

2. Rollover asset management options

Rollover IRA's are available from many organizations and/or financial institutions. If you are moving from one employer to another, the rollover may be from a 401(k) to an employer Roth 401(k). In other instances, the rollover may be from a 401(k) into an individually managed IRA. Rollover asset management options include the following:

• Employer to employer
• Employer to Insurer
• Personal business to financial institution
• Employer to Financial Institution (institutionally managed)
• Employer to Financial Institution (individually managed)

3. Type of Rollover

After choosing an IRA, there are two types of rollover, 1) direct and 2) distribution. In a direct rollover, the rollover is coordinated between your employer/401(k) manager, and the IRA manager. This method avoids the possibility of tax penalty from distribution outside the 60 day period allowed for distributions to be rolled over.

In a rollover distribution, the employee has more control over the process, but is also more responsible for ensuring the completion of the rollover. In some cases assets may be transferred from a 401(k) without having to be sold, however, in other cases cash only rollovers may be required.

4. Complete rollover and/or distribution forms

This step is somewhat self-explanatory. To execute the rollover, legal documentation has to be completed and forms are provided by the employer and IRA account issuer in order to complete this process. Some examples of 401(k) rollover forms include identity confirmation documents, IRA application and transfer receipt forms, employer authorization forms, and employee transfer authorization form.

5. Tax reporting:

As per the IRS, some 401(k) rollovers must be reported as income on tax returns in the pension and annuity line of your tax return which is comprised of an a and b box. In the a box indicate the gross amount of the rollover, however in line B of the IRS Form 1040, the value should be $0 if no other pension or annuity income is received.

Next to the b box value place the words rollover next to it so that the rollover is not taxed. In the 2008 IRS Form 1040, the pension and annuity line is within the income section of the form on line 16. For more details specific to an individual tax situation consult the IRS or a tax preparer.

In summary, 401(k) rollovers to IRA's are fairly straightforward but do require certain conditions to be met in order for the rollover to take place. These conditions are determined by the 401(k) type and policy, in addition to the regulations implemented by the U.S. Internal Revenue Service.

It is important to discuss your rollover accounts and options with your employer, IRA administrator prior to initiating the rollover to confirm eligibility for the rollover, obtain proper rollover forms and to carry out the rollover. The above steps are a general outline of what is required for a 401(k) rollover, however specific regulations, rules and policies may also apply.

Sources:

1. http://www.irs.gov