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Understanding Pensions: What They Are and How They Work

A pension is a regular payment of money that a person receives after they retire from work. Unlike a one-time payment, a pension provides ongoing income, usually monthly or annually, for the rest of a person's life or for a set period. Pensions have been a major way that workers build financial security for their retirement years.

There are two main types of pensions that exist in the United States. The first type is a defined benefit pension, which promises a specific amount of money based on factors like how long someone worked and how much they earned. Employers or unions typically manage these pensions. The second type is a defined contribution pension, such as a 401(k) or similar plan, where employees and sometimes employers put money into an account that grows over time through investments.

The history of pensions shows how retirement planning has changed. In the mid-20th century, many American workers received traditional pensions from their employers. These provided stable retirement income. Over time, more companies shifted toward 401(k) plans, which put more responsibility on workers to save and invest for retirement. Today, some workers have pensions, some have retirement savings plans, and some have both.

Understanding how pensions work matters because they can represent a significant portion of retirement income. According to the U.S. Census Bureau, approximately 18% of Americans age 65 and older receive pension income. For those who do have pensions, the average annual pension payment varies widely based on the type of work and years of service, ranging from a few thousand dollars to over $30,000 per year for some public sector employees.

Pensions differ from Social Security, which is a federal program that provides benefits based on work history and contributions throughout life. Many people receive both a pension and Social Security, while others may have only one or the other. Understanding these different income sources helps clarify the overall retirement picture.

Practical takeaway: Learn whether you or a family member worked in a job that included a pension. Government workers, military personnel, and employees of many large corporations may have pension benefits available to them.

Locating Unclaimed or Forgotten Pensions

Many people have pensions from jobs they held years ago but have lost track of them. This happens for several reasons: people change jobs frequently, companies merge or close, or individuals simply forget about retirement benefits from early in their careers. The good news is that pension money does not disappear. It sits with the pension plan administrator or insurance company, waiting to be claimed.

The Pension Benefit Guaranty Corporation (PBGC) is a federal agency that helps people find unclaimed pension benefits. The PBGC maintains a database of lost or forgotten pensions from private companies. On the PBGC website, a person can search by name to see if any pension benefits are owed to them. This service is free and does not require any payment to search. The PBGC has located billions of dollars in unclaimed pension benefits for American workers and retirees.

For public sector pensions—such as those for teachers, police officers, firefighters, and government employees—the process differs slightly. Each state and many local governments maintain their own pension systems. A person may need to contact their state's pension administrator directly. Many states now have online databases where people can search for unclaimed benefits using their name and Social Security number.

The National Association of State Retirement Administrators (NASRA) provides information about pension systems in each state. Their website lists contact information for state pension plans. If someone worked for a specific government employer, they can contact that employer's human resources or pension office to inquire about benefits.

When searching for unclaimed pensions, it helps to gather information about past employers. Think about jobs held 10, 20, or even 30 years ago. Write down company names, approximate years of employment, and job titles. If you do not remember exact company names, consider looking at old tax returns, résumés, or bank statements that might reference previous employers. Some people find it helpful to contact former coworkers or union representatives who may have records of their employment.

Practical takeaway: Visit the PBGC website (pbgc.gov) to search for unclaimed private sector pensions, and contact your state's pension administrator if you worked for any government agency. Gather information about all jobs held since age 20 to conduct a thorough search.

How Pension Payments Affect Your Taxable Income

Pension income is generally considered taxable income by the federal government and most state governments. This means that when you receive pension payments, you will owe federal income tax on at least a portion of those payments, and possibly state income tax depending on where you live. Understanding how taxes apply to pensions helps people plan their finances more accurately.

The taxability of pension payments depends on whether the pension contributions were made with pre-tax or after-tax dollars. For most private sector pensions and government pensions, contributions were made with pre-tax dollars, meaning the full pension payment is subject to federal income tax. If a portion of contributions was made with after-tax dollars (money that had already been taxed), that portion of the pension payment may not be taxed again. The pension plan administrator can provide information about how much of each payment is taxable.

Pension payments are subject to federal income tax withholding, similar to wages from employment. The pension payer typically withholds a percentage of each payment for federal taxes. The amount withheld depends on the pension amount and the taxpayer's W-4 form choices. A person receiving pension payments can adjust their withholding if they believe too much or too little is being withheld.

Some states do not tax pension income at all. As of 2024, states including Alaska, Florida, Illinois, Mississippi, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming do not impose state income tax on pension payments. Other states tax pensions but may exclude a certain amount from taxation, often for retirees over a specific age or for pensions from certain types of employment. A person should research their specific state's rules.

Example: A retired teacher in Illinois receives a pension of $2,000 per month. Illinois does not tax pension income, so she does not owe state income tax on these payments. However, she still owes federal income tax. If federal withholding is set at 12%, her monthly federal withholding would be $240, leaving her $1,760 to take home. At tax time, she would file a federal tax return to ensure the correct amount of tax was paid for the year.

Practical takeaway: Ask your pension administrator for a statement showing how much of your pension is taxable. Review your federal tax withholding to ensure the right amount is being taken out, and research your state's rules on pension taxation.

Combining Pensions with Other Income: Tax Implications

Many retirees receive income from multiple sources. A person might have a pension, Social Security, investment income, rental income, or part-time work earnings. Each income source can affect the total amount of taxes owed. Understanding how these income sources work together is important for managing taxes during retirement.

The combination of pension income and Social Security creates a specific tax situation. If a person receives both a pension and Social Security, and their combined income exceeds certain thresholds, a portion of their Social Security benefits may become taxable. The IRS calls this the "combined income" test. For 2024, if a single person's combined income (adjusted gross income plus tax-exempt interest plus half of Social Security benefits) exceeds $25,000, some Social Security benefits become taxable. For married couples filing jointly, the threshold is $32,000.

Additional income sources compound the tax picture. If a retiree receives pension payments of $30,000 per year, Social Security benefits of $20,000 per year, and has $5,000 in interest income from a savings account, their total income for tax purposes may trigger different tax brackets or affect tax credits they might otherwise receive. These income sources interact in complex ways that benefit from careful tracking.

Some income sources are not taxable, which affects the calculation. For example, distributions from a Roth IRA account are typically not taxed federally if the account has been open for at least five years and the account holder is older than 59½. These non-taxable income sources should still be considered when evaluating overall financial health, but they reduce the amount of taxes owed.

Example: A married couple,