Taxability Of Pensions
Part of your pension may not be taxed based on any after-tax contributions you made to the Plan.
Pension income is subject to federal income tax. However, part of your pension may not be taxed based on any after-tax contributions you made to the Plan. You may have made after-tax contributions for any of the following reasons:
- From 7/1/82 -12/21/96, mandatory pension contributions were collected after-tax.
- Elective purchases of service credit made by contract or lump sum payments are collected after-tax. (Trustee-to-trustee transfers from Deferred Compensation are pre-tax.)
- The voluntary 2% “opt-in” pension contribution by certain members elected in order to vest future retiree medical subsidy increases are collected after-tax. (NOTE: This does not apply to Tier 6 members.)
For all other periods, mandatory member contributions were made on a “pre-tax” basis. This means your contributions were deducted from your paycheck before income tax withholding was calculated. These amounts are “tax-free” when you contribute them. Therefore, the pension benefits provided by these contributions are taxable when you receive them during retirement.
You may have contributed both on an after-tax and pre-tax basis. The amount of your after-tax contributions will be returned to you free of federal and state income taxes as you receive your pension. “Basis recovery” is the process by which your after-tax employee pension contributions are returned to you, free of taxes, as part of your pension benefits. We will inform you of the portion of your first payment that is tax-free. The balance of each pension payment will be taxable as ordinary income in the year received. The tax-free amount of your pension will continue until you have recovered all of the after-tax dollars or “basis” you contributed to the Plan. Once your after-tax contributions have been recovered, the entire amount of all future pension payments will be taxable as ordinary income.
DROP Account Funds
The Internal Revenue Code includes a provision that allows DROP members to recover a portion of their eligible after-tax contributions using an accelerated basis recovery method. This method allows you to take a lump sum distribution of any eligible after-tax DROP funds, rather than recovering it in monthly payments over your lifetime through the Simplified Method (explained below). Members exiting DROP on or after January 1, 2014, will be subject to this accelerated basis recovery method and may:
- Recover pre-1987 after-tax contributions entirely from the lump sum DROP distribution.
- Have post-1986 after-tax contributions allocated pro-rata between the lump sum DROP distribution and your ongoing monthly pension annuity. Any after-tax funds included in the monthly pension annuity will be subject to the Simplified Method as detailed below.
Members exiting DROP must complete the DROP Distribution Election Forms within 90 days of your DROP exit date to determine how you wish to recover your after-tax contributions. After 90 days, the distribution of your DROP account will be limited to a lump sum cash payment only, subject to mandatory 20% Federal tax withholding for the entire account balance.
For pensions effective on or after January 1, 1998, the formula we use to determine the amount of your ongoing monthly pension benefit that is taxable vs. the amount that is tax-free, is the one developed by the IRS. (Also called the “Simplified Method.”) The tax-free portion is based on the amount of your unrecovered after-tax contributions at retirement and your age (plus your spouse’s/domestic partner’s age, if applicable), when you begin to receive pension benefits.
The formula determines the amount of your pension that will not be taxed and the length of time for that exclusion. (See charts below.) By subtracting the tax-free amount from your gross pension for a fixed number of months, your already taxed contributions will be recovered. Cost-of-living pension increases will not change or have any effect on the tax-free amount since the calculation is based upon your total after-tax contributions at retirement.
Simplified Method – Table I
For Retirees Who Do Not Have a Qualified Surviving Spouse/Domestic Partner
|Age at Retirement||Number of Monthly Payments to Recover Already Taxed Contributions|
|55 and under||360|
|71 & over||160|
Example: Assume a single retiree at age 55 has a monthly pension of $5,300.13 and total after-tax contributions amount to $48,656.60. The tax excludable amount is $48,656.60 / 360 = $135.16. Therefore, in this example, the taxable amount of the pension is indicated in the right-hand column below:
|Amount of Monthly Pension||Less Tax Excludable Amount for 360 Months||Monthly Taxable Amount|
In this example, the service pension would be fully taxable after 360 months.
Simplified Method – Table II
For Retirees Who Have a Qualified Surviving Spouse/Domestic Partner
|Combined Ages at Retirement||Number of Monthly Payments to Recover Already Taxed Contributions|
|110 and under||410|
|141 & over||210|
Example: Assume a 55 year-old retiree has a 54 year-old Qualified Surviving Spouse/Domestic Partner, a monthly pension of $5,300.13 and total after-tax contributions amounting to $48,656.60. Using the Simplified Method – Table II, the total amount of monthly payments to recover the after-tax contributions is calculated as follows:
Combined age 55 + 54 = 109. Number of payments for the combined age of 109 is 410. $48,656.60 / 410 = $118.67
Therefore, in this example, the taxable amount of the pension is indicated in the right-hand column below:
|Amount of Monthly Service Pension||Less Tax Excludable Amount for 410 Months||Monthly Taxable Amount|
In this example, the service pension would be fully taxable after 410 months.
If you have any questions, please call the Retirement Services Section at (213) 279-3125 or toll-free at (844) 88-LAFPP (52377).