Pension Income

Projects pension and defined-benefit annuity payments as ordinary income throughout retirement. All pension income is modeled as 100% taxable. Stratum does not implement the IRS Simplified Method for partial basis recovery from after-tax contributions. Federal, military, and state-government pensions can be flagged so state exemptions apply correctly when only those pension types are exempt.

How it works

  1. 1. Enter the annual pension payment amount

    The advisor enters the gross annual pension payment (or monthly payment x 12). This is the total distribution amount before any tax withholding. Stratum treats the full amount as taxable ordinary income.

  2. 2. Flag federal, military, or state-government pensions (optional)

    Open the line-item detail for the pension entry. If the pension comes from a federal civilian (FERS/CSRS), military, or state-government employer, enable the Federal / military / state-government pension checkbox. This flag tells the state tax engine to exclude this pension from state taxable income when the Exempt federal pensions scenario assumption is active. Do not set this flag on private-employer pensions.

    Example: FERS annuity: check the flag. Corporate defined-benefit pension: leave it unchecked.

  3. 3. Determine the lifecycle behavior

    Pension income is assigned to an owner (client, co-client, or joint) and ends when that owner dies. If the pension has a survivor option, the surviving spouse continues to receive payments — enter that as a separate income item owned by the surviving spouse, or model it as a joint-owned item.

  4. 4. Apply optional indexing

    If the pension includes cost-of-living adjustments (COLAs), enable income indexing in the Assumptions panel. The pension payment grows annually at the global inflation rate assumption. Pensions without COLAs should use 0% indexing (default). Note: the FERS diet COLA applies to the basic FERS annuity but NOT to the FERS Special Retirement Supplement.

    Year N Payment = Initial Payment x (1 + Index Rate)^(N - Start Year)

  5. 5. Flow into ordinary income tax calculation

    The full pension payment is added to AGI as ordinary income each year. It is taxed at the client's marginal federal income tax rate alongside wages, IRA distributions, and other ordinary income.

Real-world context

Use cases

  • Retirement income planning for pension recipients
  • Comparing pension annuity vs lump-sum rollover to IRA
  • Determining total retirement income for tax bracket management
  • Evaluating Roth conversion opportunity before pension begins
  • Federal employee retirement planning (FERS annuity + SRS + TSP)

Regulations

Pension taxation governed by IRC 72 (annuities) and IRC 402 (qualified plans). Most employer pensions are fully taxable because contributions were pre-tax. After-tax pension basis recovery uses the IRS Simplified Method (IRS Publication 575) which is NOT modeled in Stratum; the advisor should enter only the taxable portion of each payment if basis recovery applies. State exemptions for federal, military, and state-government pensions vary by state; the isFederalPension flag enables correct state tax treatment when the Exempt federal pensions assumption is active.

Strategic considerations

Lump Sum vs Annuity Decision

Many pensions offer a lump-sum option at retirement. A lump sum rolled to a Traditional IRA is tax-free at rollover and taxed as distributions are taken. For projection purposes, model the lump-sum-rollover scenario by entering IRA assets rather than pension income.

Pre-Pension Roth Conversion Window

Before the pension start date, the client typically has lower ordinary income making that period the optimal window for Roth conversions. Once the pension begins, the guaranteed income stream fills lower tax brackets, reducing the room available for tax-efficient conversions.

Pension and Social Security Taxation

Pension income counts toward the provisional income test for Social Security benefit taxation. High pension income can cause up to 85% of Social Security benefits to become taxable. The projection automatically reflects this because all ordinary income flows into the same AGI used for the SS taxability test.

Federal Pension Flag and State Tax Exemptions

Some states (Pennsylvania, New York, Virginia, and others) exempt government pensions from state income tax while continuing to tax private-employer pensions. Mark each federal, military, or state-government pension with the federal pension flag in the line-item detail. Then enable Exempt federal pensions in the Assumptions panel to apply the correct state exemption. Private pensions in the same household remain taxable at the state level.

Simplified Method Not Modeled

If the client made after-tax contributions to their pension plan, a portion of each payment is technically a tax-free return of basis under the IRS Simplified Method. Stratum does not model this. Enter only the taxable portion of each year's payment to reflect the correct treatment.

What drives the result

Pension Payment Amount

Full amount added to AGI as ordinary income each year

Direction: increasesMagnitude: High: typical annual pension $30k-$80k, all taxable
Federal Pension Flag

When checked on a pension line item, this flag tells the state tax engine to exclude the pension from state taxable income if Exempt federal pensions is active in the Assumptions panel and the state does not already exempt all retirement income.

Direction: decreasesMagnitude: High for clients in states like Pennsylvania or Virginia that exempt only government pensions. A $40,000 FERS annuity in Pennsylvania (3.07% rate) represents $1,228/year in state tax savings.
Income Indexing (COLA)

Enables annual growth of pension payment at the inflation rate assumption

Direction: increasesMagnitude: Moderate: 2.5% COLA on $50k pension adds ~$1,250/year in taxable income
Owner Assignment

Determines when pension ends (at the assigned owner's death). Survivor pensions should be modeled as separate income items.

Direction: mixedMagnitude: High: incorrect owner assignment can misstate retirement income by many years

Assumptions

  • Pension payments are entered as the full gross annual amount before withholding
  • 100% of each payment is taxable unless basis recovery applies (not modeled)
  • Pension income ends at the assigned owner's life expectancy (or death year in survivor scenarios)
  • COLAs modeled only when income indexing is enabled in the Assumptions panel; flat otherwise
  • The federal-pension flag affects only state tax treatment; federal tax is unchanged

Limitations

  • The IRS Simplified Method for partial tax-free recovery of after-tax pension contributions is not modeled. Advisors should enter only the taxable portion of each payment if basis applies.
  • Joint-survivor pension provisions must be modeled manually by entering a separate income item for the surviving spouse.
  • Variable annuity payments that fluctuate with investment performance cannot be modeled dynamically; use an estimated average payment.
  • Disability pension rules (partially tax-free before minimum retirement age under IRC 105) are not modeled.
  • State partial exemptions (e.g., states that exempt only the first $X of pension income or apply age/income thresholds to the government-pension exemption) are not modeled. The federal-pension exemption is binary.

Related

This page explains how Stratum models this calculation. It is educational material for financial professionals, not tax or legal advice, and tax law changes. Verify current figures against primary IRS sources before relying on them with a client.