Pension funds are a type of plan where employers, employees, or a combination of both pays into a fund to provide retirement benefits to employees. This pension money is invested in a variety of financial securities over many years. The money grows and is paid to employees to provide them with an income during retirement.
- A pension fund is a plan where employers and employees make contributions to help fund future retirement benefits for the employee.
- Typically, pension funds don't have to pay capital gains taxes.
- Because pension funds are exempt from paying capital gains taxes, assets in the funds can grow faster over time.
- While the pension fund does not pay capital gains taxes, distributions to the employee will be taxed at the employee's ordinary income rate.
Pension Funds and Taxes
Pension funds build up assets over time and provide individual employees with benefits after they retire. Each employee usually has the choice to accept a lump-sum payment from the pension at the time of their retirement or to receive monthly income payments.
Capital gains tax is due on realized profit from the sale of certain types of assets, such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Capital gains tax is broken out into two types: short-term capital gains tax and long-term capital gains tax.
Short-term capital gains tax refers to realized profits from the sale of securities that were bought and sold in one year or less. Long-term capital gains tax refers to realized profits from the sale of securities bought and sold in a period longer than one year.
The tax rates on these gains are different. For assets such as stocks, bonds, and funds, the long-term capital gains tax rate can be 0%, 15%, or 20%, depending on the individual's or entity's income level. The short-term capital gains tax is the same as the individual's or entity's ordinary income rate.
Since pension funds normally invest in these types of assets, one would expect that they need to pay these taxes; however, pension funds are exempt from paying capital gains tax. This creates unique opportunities for asset growth within pension funds.
How a Pension Fund Benefits From Not Paying Capital Gains Taxes
Typically, pension funds don't have to pay capital gains taxes, which allows the assets in the funds to grow faster. Consider a pension fund with an initial balance of $10 million growing at 10% each year for five years and paying zero capital gains taxes.
Assume that at the end of each year the entire portfolio is rebalanced and all investments are sold and replaced with different ones. At the end of the five years, this fund grows to approximately $16.1 million and pays no capital gains taxes in the process.
Roth IRAs are paid with after-tax dollars so you avoid paying taxes when you withdraw the money in retirement.
Now, imagine a hypothetical second scenario in which pension funds must pay taxes. A fund with an initial balance of $10 million and growing at 10% each year would be worth $15.04 million at the end of five years if it was fully rebalanced at the end of each year and capital gains taxes were 15%; however, the fund would have to pay $889,000 in total capital gains taxes.
Because the pension fund in the first scenario does not have to pay capital gains taxes, it saves that money ($889,000 in this scenario). Since that money remains in the pension fund, it grows as well, adding another $180,000 of capital to the pension balance.
Taxes on Employee Distributions
While the pension fund itself does not have to pay capital gains taxes, the distributions to the employees will be taxed at the beneficiaries' income rates.
If an employee uses their pension fund distributions to make their own investments, that money will be subject to capital gains taxes in the year that any realized gains occur; however, since the pension fund is tax-exempt prior to distribution, it results in a larger retirement benefit for the employee.
While pension funds are not required to pay capital gains taxes, the corporations that supply the pension funds do pay corporate taxes. This amount may have some effect on the amount that the companies pay into their employees' pension funds, which may have an effect on investor balances.
What Pensions Are Exempt From Taxes?
The pensions that are exempt from state taxes depend on the specific state but can include government pensions, including military pensions. Private pensions and annuity income can also be exempt up to a certain amount, which varies on the specific state.
Do Pensions Count As Earned Income?
Pensions do not count as earned income, along with unemployment, annuities, welfare benefits, Social Security, and workers' compensation.
Do I Have to Pay Taxes on My 401(k)?
As a 401(k) is funded with pre-tax dollars, yes, you will have to pay taxes on the withdrawals of your 401(k). At the time of withdrawal, the idea is that you are retired and, therefore, in a lower income tax bracket, and your taxes will be lower.
The Bottom Line
Pension funds are retirement vehicles for working individuals where either they, their employer, or both contribute to the plan. Upon retirement, account holders receive a lump sum or monthly payments.
And though the money in pension funds is invested in securities, such as stocks and bonds, which require payment of taxes when sold, pension funds do not need to pay taxes, which makes them a great opportunity for growing one's wealth.