Posted by The TaxAdvocate Group, LLC

Should I Go With The Lump Sum Option From My Pension?

Should I Go With The Lump Sum Option From My Pension?

A pension in any form, either in the form of a lump sum or an annuity (sometimes called a retirement pension) or a combination of both, is a valuable and increasingly rare advantage. It's an important retirement decision. It is advisable to take your time and think carefully about all the options. A lump sum may sound attractive, of course, but consider the tax implications as well as the potential benefits of spreading payments over a longer period.

The best option for you will depend entirely on your situation. Let's take a look at a few things to consider before making this important decision.


Start by understanding the calculation involved.

When you start to do the analysis, it can be helpful to compare the numbers. For example, suppose you are trying to choose between a lump sum of $300,000 or a lifetime income of $2,000 per month. This works out to an annual return of 5.17% if you live another 20 years. In other words, if you took the full amount and invested on your own, you should get an average annual return of 5.17% to an equal income of $2,000 per month for 20 years.

However, this is not a straightforward comparison. Lifetime payments include the return of some of the initial contributions as well as the return on investment. It also guarantees that you will receive the same income if you live more than 20 years. 5.17% of the total investment is a return on your money. The actual results of your investment may be better or worse without guarantees.

What complicates the analysis is whether your retirement income has a cost of living adjustment that can increase your payments to keep up with inflation. This is an important factor because you can lose significant purchasing power over time without a cost of living adjustment.


Health and life expectancy are essential.

Let's continue with the previous example. If you take the full amount, the longer you live for more than 20 years, the higher the annual return will be on lifetime income payments. Instead, the shorter your life, the more valuable the total amount will be. Take an honest look at your family's health and longevity history before making a decision.


Consider the impact on your loved ones.

If you choose to pay for lifetime income, you may have options to lower your monthly payments, but you will continue to pay your spouse or other survivors' lifetime income. On the other hand, a lump sum could offer more flexibility or advantages to other beneficiaries.


Consider the rest of the finances.

Suppose you have significant financial resources (brokerage, 401(k), IRA, business assets) and other reliable sources of monthly income (for example, social security or rental income). In that case, you might need another source of income for life. Taking a lump sum can help you pay off your debts. On the other hand, if you are keen to cover essential monthly expenses and like the idea of having a guaranteed source of monthly income, it might favor the annuity instead of a lump sum.


Be honest about your investment skills, interest, and desire for control.

Taking out a lump sum requires discipline and skill. If you work with an advisor or are a seasoned investor and are willing to invest some time in it, the lump sum may be a good option, but don't forget to factor in taxes. However, if you are unsure of your investment capacity or prefer to spend time doing other things in retirement, a lifetime income may be a better option.


Assess your risks

Both options involve a certain degree of risk. If you choose a lump sum, the employer transfers all investment risk to you. It could be better or worse than the lifetime income option. Another concern is the possibility of overspending and running out of money or longevity risk.

In contrast, choosing a lifetime income carries risks, such as premature death, the loss of a better return on investment, or the existence of retirement assets that lose value if the plan is not—properly funded. The Pension Benefit Guaranty Corporation (PBGC) offers some protection to participants in private pension plans; if you work in the government sector, your employer usually offers guarantees through federal, state, or municipal governments.


Think about taxes

If you receive monthly income, your payments are subject to normal income tax. If you receive a fixed amount of cash, you will be immediately taxed and subject to mandatory federal (and potentially state) 20% withholding tax. With a few exceptions, distributions made before age 59½ are subject to a 10% early withdrawal penalty from the IRS. Withdrawals must not begin before the age of 72.

Alternatively, you can probably transfer the entire amount to a traditional IRA or possibly another employer plan and defer taxes until you make future withdrawals.


You can have multiple options.

Sometimes having multiple options helps a lot. Depending on your plan, you will be able to participate in the plan balance in a single payment and the rest in a series of rents. Other options may include retirement at a later date. Make sure you understand the details and how these agreements will affect your full payment.

As you can see, choosing between a lump sum and a lifetime payment is a complicated decision. When evaluating your options, it can be very helpful to consult a trusted professional. If you are married, it is also essential to consider your spouse. Your choice will affect you both for many years to come, so take the time to make an informed decision.


Summary

  • A lump sum gives you more control and flexibility but also more responsibility for managing income.

  • Choosing between a lump sum or lifetime income is a crucial and complicated decision. Be sure to consider the pros and cons of the options available.

  • When comparing annuity income with a fixed amount for retirement, one is not universally better than the other. The best option depends on individual circumstances.


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