Even though you're no longer working for your money, Uncle Sam still expects a cut of your pension payments each year. If you didn't contribute any after-tax dollars to your pension, the entire payments are taxable. However, if you did, calculating the taxable portion allows you not to pay taxes on the same income twice. If you started taking your pension after November 18, 1996, you generally have to use the so-called simplified method to figure the taxable portion of your pension payments.
Look up the number of months over which you get to recover your cost for your pension based on the tables in Worksheet A in IRS Publication 575. The number of months is based on your age and, if the pension is based on both your life and the life of your beneficiary, your beneficiary's life as well. For example, for the 2012 tax year, if the pension is only payable during your life and it started paying when you were 59, use 260 months.
Divide your cost by the number of months from the table to figure how much of your cost you can recover each month. For example, say you invested $26,000 in after-tax dollars in your pension. Divide $26,000 by 260 to find you can recover $100 per month.
Multiply the recovery per month by the number of months during the year that you received payments from your pension. For example, if your payments covered all 12 months, multiply $100 by 12 to get $1,200 of potential cost recovery.
Subtract your cost recoveries from prior years from your cost to find the cost remaining in your pension. For example, if you already took $5,000 of tax-free distributions, your plan has $21,000 in cost basis remaining.
Select the smaller of your potential cost recovery or cost basis remaining as the tax-free portion of your pension. In this example, since $1,200 is less than $21,000, $1,200 of your pension is tax-free.
Subtract the tax-free portion of your pension from your total pension payments to figure the taxable portion. In this example, if your total pension payments for the year total $40,000, subtract $1,200 to find that $38,800 is taxable.
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