What Are Fully Taxable Pensions & Annuities?

Pension plans and annuities are just two of the investment instruments you can use to save for retirement. Pension plans are typically sponsored by your employer, while an annuity is purchased from an insurance company. Both are designed to provide you with a steady stream of income after you stop working, but you will have to pay taxes on your benefits. Certain pension and annuity payments are fully taxable, while others are only partially taxable.

Fully Taxable Benefits

The Internal Revenue Service has specific guidelines that determine to what degree your pension and annuity benefits are taxable. According to IRS Publication 575, money you receive from a pension or annuity is fully taxable if you don't have any investment in the contract, if your employer didn't withhold contributions from your salary or if you got all of your contributions back tax-free in prior years.

Defined benefit plans, for example, are fully taxable because they're funded solely by employer contributions. Withdrawals from an annuity are considered fully taxable until the account value equals the initial amount that was invested. Withdrawals of earnings are always fully taxable.

Federal Withholding Tax

Pension and annuity payments are also subject to federal withholding tax at the time your benefits are paid. The withholding is generally calculated using the same basis as for salaries or wages. You can opt out of paying the withholding or elect to withhold a different amount, but you must complete Form W-4P, Withholding Certificate for Pension or Annuity Payments, to do so.

If you don't specifically opt out, the entity that pays your pension or annuity benefits is required to withhold tax as if you were married and claiming three allowances. If you decide to forgo paying the withholding, you may need to make estimated tax payments to avoid a penalty.

Penalties and Exemptions

In addition to paying income tax on your pension or annuity plan distributions, you could be hit with an additional penalty for taking an early withdrawal. If you begin receiving pension or annuity benefits before age 59 1/2, the 10 percent penalty will apply unless you qualify for an exemption. The IRS allows exemptions for distributions made because of a total and permanent disability, distributions made to your beneficiary after your death, distributions made as part of a series of substantially equal periodic payments that began after you left your job and distributions made after you left your job if you're at least 55.

Partially Taxable Payments

If you made contributions to a pension plan or invested money in an annuity contract, your benefits are only partially taxable. You won't have to pay any tax on the amount of your payment that represents a return of what you initially invested. Depending on when you started receiving benefits, you can use the general rule or the simplified method to calculate the tax-free portion of your benefit payments.

The general rule uses your life expectancy to calculate the tax-free part of your annuity payment. The simplified method uses your age and how much you paid in to determine what part of your benefits is tax-free.