The taxation of annuity and pension payments. The annuitant is taxed on only that part of his or her annuity which is regarded as interest. The balance, a return of capital, is taxfree. Retirement annuities (pensions) are taxed as earned income, but part of the benefits can be commuted to a tax free lump sum, often used to purchase an immediate life annuity a part of which is a return of capital and therefore tax free.