- A pension system may use an annuity arrangement indexed for inflation. Annuities, which are insurance policies designed and issued by insurance companies, guarantee a monthly payment to you in exchange for a lump sum payment. When pensions use annuities, the savings come from your employer. Inflation-adjusted annuities provide increasing payments each year based on changes to the consumer price index.
- The increase in the monthly payment received may fluctuate because it follows the consumer price index. While future payment increases are unknown until the insurer announces its payment increase for the following year, the increase is guaranteed. Insurance companies use inflationf-adjusted investments to reduce the initial payout and boost invested funds in the future, when interest will be added to the payments. All of these progressive payouts are taxed at ordinary income tax rates. These amounts are reported as income on line 16b of Form 1040, line 12b of Form 1040A or line 17b of Form 1040NR. If you contributed to your pension on an after-tax basis, you exclude the amount you contributed from reportable income.
- Increasing or progressive payments also eliminates the need for you to earn additional interest on your other savings to compensate for inflation. This means that the money you retire with can be used for other purposes such as an emergency fund. The benefit payment promised to you when you retire should sustain you for the rest of your life.
- When you retire and collect a pension, consider taking your full pension indexed to inflation if it is offered. If your pension does not offer progressive payments, search for life insurance companies selling inflation-adjusted annuities. An insurance company will give you a progressive income benefit payment under an inflation-adjusted annuity contract. Normally, private annuity contracts are guaranteed for life, so you'll get the same or similar income benefit as you would have under a pension plan.
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