A pay-as-you-go pension plan is the broad term for a type of defined-benefit retirement scheme in which the contribution levels of individual participants directly impact their future payout amounts. Nearly all Americans receive some form of pay-as-you-go pension benefits through Social Security, and some might receive more through employer-sponsored pensions. When you receive your pension annuity payments through an employer's pay-as-you-go plan, some or all of the benefit amount may be subject to taxation.
A portion of your Social Security income is taxed. The level of Social Security benefit taxation depends on your income level.
As with any qualified plan, you pay an early distribution tax penalty if you elect to receive any employer-sponsored pension payments before you turn age 59.5 unless you qualify for an exception.
Nearly all pay-as-you-go pension plan payments are made with pre-tax dollars
that are regularly deducted from your paychecks. Since the money went into the plan before being taxed, the full amount of the pension benefits is subject to income taxes. If you happened to contribute any after-tax dollars to your pension during the accumulation phase, then you do not pay taxes on the part that represents the return on the after-tax amount that you paid.
The calculation of partial income taxation for pension benefits is either done through the General Rule or the Simplified Method, both of which are explained in Internal Revenue Service Topic 411 .
Generally, any taxable parts of pay-as-you-go pension payments are subject to federal income tax withholding. Withholding for regular payments is figured in roughly the same way as withholding for wages. Lump-sum pension benefits have a special tax treatment, outlined in IRS Topic 412.