In the United States, according to the Internal Revenue Service (IRS), all pensions received by individuals are considered taxable income, and there is no federal pension deduction. In some circumstances, however, a portion of a pension may be excluded if the taxpayer used after-tax dollars to contribute to that plan. In this case, the taxpayer may exclude a portion of his pre-tax investment annually.
Some pension funds calculate this and include the taxable amount on the Form 1099-R. If the fund does not make the calculation, then the taxpayer can figure the amount himself using IRS worksheets or pay the IRS a fee to calculate it for him. A pension deduction does exist for businesses that put money into employee retirement funds.
State tax laws, however, are not tied to IRS regulations and have varying ways of treating pensions. Ten states do not tax pensions at all. Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming do not have individual income tax, and New Hampshire and Tennessee only tax interest and dividends. Illinois does not tax pensions for taxpayers who have reached retirement age, and Hawaii only taxes the portion of a pension which represents the employee’s tax-deferred contributions.
Several states only allow a pension deduction for certain types of retirement income. For example, California, Connecticut, Indiana, Iowa, Nebraska, New Mexico, and Rhode Island tax every pension except railroad retirement. Other states offer a pension deduction for a variety of other groups, such as state, federal, or local government employees; military; teachers; police officers; or firefighters. In the case of New Mexico, pensions paid to retired Native Americans who worked for the tribe and live on tribal lands are also excluded from taxation.
A common practice among the rest of the states is offer a limited pension deduction. This is the case in Arizona, Idaho, Illinois, Iowa, Massachusetts, Michigan, North Carolina, North Dakota, Ohio, and Washington D.C., primarily for military or government pensions. Sixteen states offer a limited pension deduction for all types of retirement funds. A few state tax codes, such as Maine, Missouri, Montana, Oklahoma, and Utah, phase out the deduction if the taxpayer’s adjusted gross income (AGI) goes over a certain amount.
How a state taxes pension plans is one thing to consider when picking a location to retire, yet it should not be the only factor. Just because a state does not tax pensions does not necessarily mean it is an inexpensive place to live. A person should also consider property and sales tax, cost of living, and other personal preferences.