How Capital Gains Tax Works on Pension Funds

Pension funds are a type of plan where employers, employees or a combination of both pay 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.

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 his or her 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, which refers to realized profits from the sale of securities that were bought and sold in less than 365 days, and long-term capital gains, which refers to realized profits from the sale of securities bought and sold in a period longer than 365 days. The tax rates on these gains are different. For assets such as stocks, bonds and funds, the long-term capital gains tax rate ranges from 15 to 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.

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.

Now, imagine a hypothetical 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 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.

While the pension fund itself does not have to pay capital gains, the distributions to the employees will be taxed at the beneficiaries' income rates. If an employee uses his or her pension fund distributions to make his or her 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.