In the United States, IRS' Publication 939 differentiates between pension and annuity for the purpose of calculating taxes. According to it, pension is regular payment received by a taxpayer from former employer, after retirement for services rendered in past, while annuity is something taxpayer voluntarily contracts for. However, the employer may help employees in selecting and managing such contracts. Annuities are paid annually and for more than one year. There are different types annuities, such as fixed period annuities, variable annuities, annuities for a single life, or joint and survivor annuities.
While in employment, employees without defined benefit, i.e., without salary related pensions, contribute regularly to some annuity pension plans. At the time of retiring, the employee may have a choice to receive either pension annuity or lump sum from these pension plans. The employee can shop around for suitable pension annuity rates, and use the lump sum received under the plan for purchasing suitable pension annuity income. Alternately, the employee may invest lump sum in any life annuity pension plan and choose to receive regular income from it. Pension plans are offered by insurance companies and are used for retirement planning. Employers' contribution towards employees' pension also goes into pension and annuity funds with the insurance company. This is used to purchase annuity for the employee at the time the employee retires.
There are some tax credits associated with pension and annuity income, as well as contribution towards pension annuity plans. Pension annuities in UK are classified into four different types, the personal pension, the occupational/company pension, the stakeholder pension, and the State Pension. Taxpayers without defined benefits can enter into contracts with a pension provider for personal pension. The employer contributes towards occupational pensions in UK. Stakeholder pensions are quite like personal pensions, but here there is some flexibility built in to enable people with moderate incomes purchase such pension plans. State Pensions are given by the government, but are rarely enough because of which it becomes necessary to purchase other types of personal pensions.
In the United States, any payments towards annuity, and pension are subject to some federal income tax withholding which is nothing but tax deducted at source. A certificate for pension or annuity is issued to the taxpayer for any tax withholdings. Taxpayer can choose not to have such deductions, or have lesser income tax withheld. In such cases, the taxpayer is required to pay an estimated amount of tax.
Two methods are used in the United States to identify how much of annuity is tax-free and how much is taxable. General rule is one of them, and the other method is explained in IRS' Publication 575. General rule is applicable only to annuity payments under non-qualified plans, and to those qualified plans that were taken before November 19, 1996. Publication 939 defines a non-qualified employee plan as the one that does not conform to the Internal Revenue Code. Some employers do have such plans, which do not entitle their employees to most of the tax benefits associated with qualified plans.
Such method of identification of taxable and tax-free components of annuity under General Rule is also applicable to guaranteed annuity payments to people who are 75 or older, provided there are five more years of such guaranteed payments remaining. The General rule is not applicable on qualified employee plan, qualified employee annuity and tax-sheltered annuities, provided the starting date of these annuities is later than November 18, 1996. Annuity worksheets allow the taxpayer to identify the part of the annuity that is taxable. The Simplified Method under Publication 575 is applicable in all other cases where General Rule is not applicable for identification of taxable component from annuities. Form 1040 Line 16 is used to report Pension and Annuity incomes and taxable components. Relevant information is to be filled from 1099-R from all sources.
