Most pension plans meet the requirements of Internal Revenue Code 401(a) and Employee Retirement Income Security Act of 1974, which allows them to enjoy tax advantages.
Both employers and employees make contribution to the investment fund from their gross income thus their taxable income is decreased and they can get a tax break.
Investment funds are placed in a retirement account and it grows at a tax-deferred rate. Before retirement, employees will not withdraw money from this account and as long as they are in the retirement account, employees do not need to pay tax on their earnings. Due to this, employees can rearrange their investment plan regarding capital gains, dividend income, and interest income in order to get a higher return.
When employees retire, they will receive funds from their pension and their tax status is based on their contribution plans.
If employees choose to invest nothing in their pension plans, their pension or annuity is fully taxable. This includes two possibilities. One is employers keep nothing back from their workers’ salary for their pension plan. In this case, employees must report that amount on their tax return and when they file the return, they ought to pay the tax. The other possibility is that employees receive all the contribution tax-free in the earlier years. This one is usually related with 401(k) and IRA account. Although employees do not need to pay the tax before, once they start to withdraw their money from the account, they need to pay the tax.
If employees choose to make contribution with after-tax dollars which is the money that employees do not receive tax break before, only part of their pension is taxable. Employees can just pay the part that has received tax break before. For the taxable part, it is levied according to the Simplified Method.
Note that if employees retire early and withdraw their money before fifty-nine-and-a-half, they will face a penalty, except they leave because of illness and disability.