2 Ways to Lower Taxes on Pension Benefits

There are a number of pension structures to consider, and each will offer its own tax benefits. The IRS provides for tax advantages on pensions to encourage saving for retirement. This means there are incentives to put the money aside, and you can capture those incentives if you are aware of the different options.

#1 Elect a Roth Option

You should know the tax structure on your current pension election. There are two primary options for retirement funds: 401k and IRA. Each of these has a different way of taxing income that is placed in the account. Recently, the Roth option was introduced, that also has a unique structure for those who make less than a given income cap.

  • 401k options allow you to place pre-tax income into a pension fund. The funds grow tax free in the account. When you collect your distributions, however, you will have to pay taxes at that point at your given tax rate.

  • IRA funds are post-tax dollars. However, you then deduct the contributions from your taxable income in a given year. Like a 401k, funds grow tax free, but distributions are taxed later at your tax rate at the time of collecting.

  • The Roth option for both 401k and IRA accounts allows you to contribute post-tax dollars to an account. The funds grow tax free, and you are not taxed later when you withdraw the funds.

If you qualify for the Roth option based on your income, you should consider taking it. This allows you to pay taxes once at your current income rate and then avoid taxes later, when your tax bracket is likely going to be higher.

#2 Consider a Rollover

Based on the taxable structure of your pension, you may discover you can reduce your tax liability if you change to another type of account. In this case, you can consider a pension rollover. You will need to be sure to do this appropriately to avoid any penalties. There is a 10% penalty on any early distribution from a pension fund; this penalty applies to both the 401k and IRA options. An early distribution is one taken before you reach 59 1/2, regardless of the type of account you currently have.

The key thing to remember is this: the funds must hit the new pension account within 60 days.

  • The first way to rollover your funds is to have a pension administrator do this directly. The funds move straight from one pension account to another, without ever stopping in your possession. This is the safest way to avoid any fees because there is very little room for error.

  • The second way to rollover your pension is to have a check made out to you then deposit the check in the new account. You can use the funds if necessary during this time period, but you must replace any funds you use by the time they are deposited into the new pension account. If you fail to make the deposit in full within 60 days, you will be charged for an early distribution.