Lump Sum Distribution or Monthly Pension: Which to Take?
Traditional pension plans are most commonly available to employees of federal, state, or local governments, and their agencies. Most private employers have converted to 401k plans, but some still offer them, particularly for long-time employees. These plans are known as defined benefit plans because they guarantee payment of a lifetime retirement income to eligible employees who become vested, and reach the plan's specified retirement age. The amount of the monthly benefit is determined by a formula, which uses factors such as the employee's age, years of service, and income. Once the benefit begins to be paid, it is guaranteed for as long as the employee lives. Plans may also offer options such as cost-of-living increases, and spousal/survivor benefits, which may continue payments after the death of the employee.
Some employers fund cash balance plans, which also offer the option to elect a lifetime income payout.
Many pension plans give retiring employees the option to elect a lump-sum payout. Some plans offer a lump-sum payout of the entire amount of the employee's vested benefits, with no monthly income payments. Other plans may offer a partial lump-sum option, with the remainder of the benefit paid out as lifetime income payments. Plans may also offer employees who leave employment prior to retirement the option to take a lump-sum payment upon termination.
The decision to take a lump-sum distribution, or a monthly pension is an important one that can have a major impact on the quality of your retirement. This decision should never be taken lightly, and requires careful consideration of the potential advantages and disadvantages of each option. You may want to consult with a professional financial advisor, and tax accountant for help with your decision.
Here are some important things to consider about each option:
Potential Advantages of Taking a Lifetime Monthly Income Benefit Option:
- Provides a monthly income that you cannot outlive.
- You are not responsible for making investment decisions, and your individual benefit is not affected by poor investment performance.
- You can elect to have monthly payments continue for the life of your spouse, or other beneficiary, if they outlive you. Note however, that if you elect a survivor option, the monthly income you receive will be less than you would have received for your lifetime only. The amount of the reduction will be based on the difference in age between you and your beneficiary, and the percentage of your monthly income that will continue to be paid to the beneficiary after your death.
Potential Disadvantages of Taking a Lifetime Monthly Income Benefit Option:
- Your decision is usually irrevocable. Once you begin receiving benefits, you cannot change your mind. You cannot go back and take a lump-sum. You cannot change the amount of the income payment, or elect to stop taking income if you no longer need it. Some plans may allow you to name a new beneficiary, or revert to receiving the higher amount of your own individual monthly benefit if your first beneficiary dies before you do.
- The monthly payments stop at the time of your death (or the death of your survivor, if you elected a survivor option, and they outlive you), even if you have only been receiving benefits for a short time. Pension plans are designed so that the funds of participants who die soon after beginning benefits remain in the plan to support participants who live longer than average.
- Unlike the lump-sum option, there is no guarantee of the total amount that you, or your survivor, will actually be paid out from the plan. After your death (or your survivor's if later) no funds will be paid to another beneficiary. Some plans may pay out some remaining funds to a beneficiary if you contributed to the plan during your working years.
- Monthly benefit payments are fully taxable in the year they are received. If you don't actually need the income to meet current year's expenses, pension payments can cause you to pay unnecessary taxes, and may even trigger additional taxation of your Social Security benefits.
- If your plan does not include a cost-of-living benefit, your monthly payment will never increase during your retirement. If you live many years after retirement, inflation may significantly reduce the spending power of your monthly benefits over time.
- Your income can be negatively affected by the financial ability of the employer's pension fund to pay benefits. In recent years, some pension plans have been forced to reduce promised benefits to current and future retirees due to poor performance of investments held by the plan, or by inadequate contributions to the plan in prior years. Many, if not most, plans are currently under-funded, placing doubt on their ability to meet future obligations to retirees.
Potential Advantages of Taking a Lump-Sum Benefit Payout:
- If you take a lump-sum payout, you gain control of the funds, and the ability to tailor the amounts and timing of withdrawals to meet your own unique needs.
- You may avoid taxation of the lump-sum payment by rolling over all, or part, of it to a traditional IRA. Taxes will not be due in the current year on the amount rolled over.
- You may elect to roll over all, or part, of the lump-sum to a ROTH IRA, and pay taxes on the amount rolled over. This may allow you to avoid paying any taxes on the funds in the future, and eliminates the requirement to take annual minimum distributions after you turn 70.5 years of age.
- You gain the ability to invest the funds as you choose, providing the potential for better investment performance during your retirement.
- At the time of your death, any funds remaining may be distributed to beneficiaries, as you designate in your estate plan.
- You may choose to invest all, or part, of the funds into an annuity to create guaranteed lifetime income, similar to the options offered by the employer plan. Some annuities allow you to choose investment options, and retain ownership of the account value, while still guaranteeing future income amounts. With these "living benefit" options, your beneficiaries will receive any funds remaining in the account at the time of your death.
Potential Disadvantages of Taking a Lump-Sum Benefit Payout:
- You take the full responsibility and risk for managing the funds. The employer pension plan has no further obligation to pay any benefits, and there are no guarantees that the funds will last throughout your retirement, unless you purchase an income annuity with the funds.
- Your decision is irrevocable. After you take a lump-sum distribution, you cannot change your mind and elect a lifetime monthly pension benefit.
- You may lose access to other employer retiree benefits, such as health insurance. Check with your human resources office for details.
- Your spouse may lose protections that could have been provided by a survivor option under the monthly pension payment option.
- Future distributions from a traditional rollover IRA will be taxable to you and/or your beneficiaries. Taxable minimum distributions will be required each year after you reach 70.5 years of age. It will be your responsibility to ensure that these minimum distributions are taken. If you do not withdraw at least the required amount, you will be assessed a tax penalty of 50% of the deficiency.