The U.S. government taxes pensions differently depending on the source of the original pension contributions, explains the Internal Revenue Service. If an individual does not himself contribute to his pension, either directly or through paycheck withholdings, then his pension is fully taxable. This also applies if all previous contributions to the pension are tax-free.
If an individual's pension payments are the result of his own contributions of after-tax dollars, his payments are partially taxable, according to the IRS. The portion that constitutes the return of the original, capital contribution is non-taxable. However, the residual component is fully taxable. In order to calculate these amounts, taxpayers use either the Simplified Method or General Rule. The former applies to qualified retirement plans with beginning payments after November 1996, while the latter applies to non-qualified plans or, by election, to plans beginning with payments between July 1986 and the 1996 cut-off for the Simplified Method. Taxpayers prepare computations using either the Simplified Method Workseet contained in the Form 1040 Instructions, or Publication 939, General Rule for Pensions and Annuities.
Taxpayers can often also determine their tax liabilities for pension incomes using information provided directly by their financial institutions in Form 1099-R, notes TaxSlayer.com. However, this applies only when the retirement plan manager has sufficient information on hand to complete this calculation.