You are getting ready to retire, and you have a defined benefit pension that will kick in once you stop working. You may have the option of taking the pension in the form of a one-time lump sum distribution or as lifetime monthly payments. So, which should you pick?
It can be a daunting decision to make since once you opt for one or the other, you will be locked into your choice. Unfortunately, there is not a one size fits all answer to this question, and what’s best for you will depend largely on several factors including your financial situation, life expectancy and personal preference.
First, let’s discuss the difference between a single lump sum payment and lifetime monthly payments. With the lump sum option, you will receive a large single payment at retirement. With lifetime monthly payments, often referred to as annuity payments, you will receive much smaller monthly payments for the duration of your lifetime.
Choosing the Lump Sum Election
If you choose the lump sum payment, you get one large payout, and that is it. Once the money is distributed, you are in control of it and can invest or spend the funds as you see fit. This option may be the best choice for individuals who want to take advantage of the growth potential of investing and are not as concerned about having a fixed, steady stream of income that can help them meet basic day-to-day expenses in retirement.
The lump sum option provides greater financial flexibility to the recipient and can open you up to a greater number of investment strategies as you make your way through retirement. If you like the idea of monthly income but want to remain in control of how the funds are invested, you could elect the lump sum and use a portion of the proceeds to purchase an investment vehicle that offers a lifetime income stream. The lump sum option can also be beneficial in the event large, unplanned expenses arise such as a needed home repair or a medical emergency.
Qualified pensions taken as lump sums also have the benefit of being tax deferred if they are rolled into an IRA. In most cases, the recipient will roll the qualified lump sum payment into an IRA, so taxes on the money won’t be due until the money is taken out as taxable income. Keep in mind, once you turn age 72 ( age 70½ if you reached 70½ prior to Jan. 1, 2020), the IRS will require you to take taxable Required Minimum Distributions (RMDs) from qualified accounts. It should also be noted the Coronavirus Aid Relief and Economic Security Act (CARES Act), signed into law on March 27, 2020 suspended RMDs for 2020.
If there are funds left over following the recipient’s death, the money can be passed on to other heirs. For individuals who want to build a financial legacy and leave something to their children or grandchildren, the lump sum may be the more appropriate option. Individuals in poor health or with a shortened life expectancy may also want to consider choosing the lump sum option since it will likely take many years of monthly annuity payments to produce the same income as the larger lump sum distribution.
A potential drawback in electing the lump sum option is there is no guarantee the money will last throughout your lifetime. While prudent investing and sensible spending can help safeguard a successful retirement, there are no guarantees investments will pan out. Even the most conservative investments have the potential to lose money.
There are also no guarantees individuals will be responsible in handling a large sum of money. Choosing the lump sum option can invite overspending if the recipient isn’t financially savvy or doesn’t have a good grasp of their current and future cash flow needs. Even if overspending is not an issue, you still could spend the whole of the lump sum amount over the course of several years after covering basic retirement expenses. The longer you live, the greater the chance is you could outlive your money.
Choosing the Monthly Annuity
A benefit in choosing the monthly annuity option is you will receive guaranteed monthly payments that will last throughout your lifetime. This guaranteed income can play a vital part in helping to budget and in planning to cover basic expenses in retirement.
While taking the annuity may not offer the same reward in terms of return potential, it is often considered the less risky of the two options, because the monthly payments are not reliant on the performance or returns of investments. If you prefer the security and peace of mind of knowing you will receive a monthly check for the rest of your life, the annuity option is a good choice.
Many pension administrators offer survivor benefit options in which a beneficiary, usually a spouse, can be selected to continue to receive some or all of the pension payments after the recipient’s death. In choosing this option, the recipient will take a reduced monthly benefit that will continue until both the recipient and the beneficiary pass away. At that point, the payments stop.
Many pensions offer cost-of-living adjustments, which increase the monthly payment amount by a certain percentage to keep up with inflation. Individuals opting for the lump sum option will need to invest the money to protect from inflation eating away at the pension’s purchasing power. You should check with your plan administrator to find out if your plan includes survivor benefit options and a cost-of-living adjustment. If the plan does not have a cost-of-living adjustment, you should have a plan in place to address the potential impact of inflation.
Unlike the lump sum option, choosing the monthly annuity payments leaves the plan administrator in control of the money before each payment is disbursed. You will not have access to the funds until the monthly payment is received, which means you may have to turn to other funding for large or unplanned expenses.
Taxes on the monthly income will be due every year the pension is paid out, even if the recipient doesn’t need or use the money. The monthly payments are essentially treated as income and will be taxed as such.
Another consideration in choosing the annuity option is determining the long-term financial viability of your company and pension plan administrator. Defined benefit pensions have become less and less common in recent years, because they are expensive for companies to maintain. If a company falls on hard times financially or is forced into bankruptcy or liquidation, there is a chance the pension plan can be terminated.
The Pension Benefit Guaranty Corporation, created by the Employee Retirement Income Security Act of 1974, is a federally charted corporation that helps protect private pensions in the event a company sustains severe economic hardship. If the recipient’s pension is insured by the PBGC, the corporation can take over the pension, but the recipient’s monthly payments could be significantly lower than they would otherwise be.
There are benefits and drawbacks when deciding to take your defined benefit pension as either a lump sum or as a monthly annuity. In the end, the decision will come down to several factors and should only be made after thoughtful consideration and careful planning. Your retirement can last 30+ years, so it is important to implement a well-thought-out retirement strategy to help ensure you can reap the benefits of a lifetime of hard work while protecting yourself from outliving your money.
Authored by Dennis Culver, Insight Wealth Strategies
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
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