Can You Have a Pension and an Annuity?

Securing reliable and predictable income is a central challenge of retirement planning. Pensions and annuities represent two established methods for creating such income streams, each with distinct characteristics and functions designed to provide financial support throughout a person’s retirement.

Understanding Pension Plans

A pension plan is a retirement account an employer maintains to provide a fixed income payment to an employee after they retire. These are often structured as defined-benefit plans, where the employer promises a specific monthly benefit for life. The responsibility for funding the plan rests with the employer, who makes contributions and manages the plan’s investments.

The calculation for a defined-benefit pension is based on a formula that considers an employee’s years of service and salary. For instance, a formula might multiply a percentage by the number of years worked and the employee’s final average salary. This means a longer tenure and higher earnings directly translate to a larger monthly pension payment.

Upon retirement, employees are usually presented with several payout options. A single-life option provides the highest monthly payment but ceases upon the retiree’s death. A joint-and-survivor option offers a reduced monthly payment but continues to pay a portion, such as 50% or 100%, to a surviving spouse for the remainder of their life. Some plans also offer a lump-sum payment, which gives the retiree the total present value of their future pension payments in one go.

Understanding Annuity Contracts

An annuity is a contract between an individual and an insurance company designed to provide regular income payments. Unlike an employer-sponsored pension, an annuity is purchased by an individual using their own funds. The primary purpose is to create a guaranteed stream of income for retirement, helping to mitigate the risk of outliving one’s savings.

An annuity is divided into two phases: accumulation and annuitization. During the accumulation period, the individual funds the annuity with a lump sum or a series of payments. The money within the contract grows on a tax-deferred basis, meaning no taxes are paid on the earnings until withdrawn.

Once the owner decides to start receiving income, the contract enters the annuitization, or payout, phase, and the accumulated funds are converted into regular payments. The structure of these payments can vary. An immediate annuity begins payments shortly after purchase, while a deferred annuity delays payments until a future date. A fixed annuity provides a guaranteed payment, whereas a variable annuity’s payments can fluctuate based on underlying investments.

Combining Pensions and Annuities for Retirement Income

It is possible for an individual to have both a pension from a former employer and a separately owned annuity. These two financial tools can work together to create a layered retirement income strategy. They are not mutually exclusive and can complement each other to provide multiple streams of predictable income.

A common strategy involves receiving monthly payments from a pension while also drawing income from an annuity purchased with other retirement savings. This approach diversifies income sources. For example, the pension might cover essential living expenses like housing and utilities, while the annuity payments could be used for discretionary spending, travel, or healthcare costs.

Another strategy involves the decision to take a pension benefit as a lump-sum buyout instead of monthly payments. An individual can then use these funds to purchase a single premium immediate annuity (SPIA) from an insurance company. This move transfers the responsibility of providing lifetime income from the former employer to a chosen insurer and can sometimes offer more customized payout options, such as inflation protection or specific survivor benefits that the original pension plan may not have provided. This gives the retiree greater control over the capital and the structure of their future income stream.

Tax Treatment of Payouts

The taxation of income from pensions and annuities follows Internal Revenue Service (IRS) rules. Payments from a traditional pension plan are fully taxable as ordinary income at the federal level. This is because the contributions to the plan were made with pre-tax dollars and were not taxed when made.

The tax treatment of annuity payments depends on whether the annuity is classified as qualified or non-qualified. A qualified annuity, which is purchased with pre-tax funds inside a retirement account like a 401(k) or a traditional IRA, is taxed similarly to a pension; the entire amount of each payment is subject to ordinary income tax.

A non-qualified annuity is funded with after-tax dollars, so the original investment (the principal) is not taxed again upon withdrawal. Only the earnings portion of the payments is taxable. To determine the taxable amount of each payment from a non-qualified annuity that has been annuitized, the IRS uses an “exclusion ratio.” This ratio separates each payment into a tax-free return of principal and a taxable portion of earnings, ensuring that only the growth on the investment is taxed.