Considering a Lump Sum Pension Payout?
For over a century, pension plans were the primary option for providing retirees a post-work income. Though they’re much less common today, some companies and government agencies still use pensions as a cornerstone for their employees’ retirement plans.
A pension is a defined benefits plan. This means that the pension benefits you receive are defined for you, usually based on a prescribed equation. Plans like this differ from defined contribution plans (such as a 401k or IRA), where the benefits received are based on contributions you’ve made yourself.
When you receive a pension, you might get a few options for how to receive a payout. A lump sum is a one-time payment for the total value of your retirement.
While that might work for some retirees, a lump sum pension payout could immediately affect your taxes and have long-term implications for your retirement.
So, if you’re considering a lump sum for your pension, here are a few things you should keep in mind.
How do lump sum pension payouts work?
When referring to pension payouts, a “lump sum” is when you receive the total value of your pension all at once. Since most pensions pay for 10-20 years of retirement, you’ll receive up to 20 years’ worth of retirement funds in one big payment.
The value of your pension income is calculated with an equation that factors in items such as your age, life expectancy, and the current interest rate.
Lump sum vs. annuity pension payout
When you retire with a pension, you have a few options for how to receive those benefits. Where the lump sum option distributes the total value of your pension at once, the annuity pays you that value over a more extended period of time. Generally, annuity payments come in monthly installments for the 10-20 years following your retirement.
In simple terms: with a lump sum payment, you get paid once; with an annuity, you could potentially receive regular payments for the rest of your life.
One significant difference between the two options could affect your choice: what happens to your money if you predecease your loved ones?
With a lump sum, that money becomes yours. You can do whatever you’d like with it, including willing it to your spouse or offspring.
Annuity payouts are different. Single-life annuities don’t continue paying after you pass. Spousal benefits options exist but generally result in reduced pension income. Alternatively, you could attach spousal benefit insurance to a single-life annuity if that fits within your budget.
Can a lump sum pension affect my retirement?
As a retirement plan, opting for the lump sum could have unintended consequences. Avoiding some of these consequences is possible with a little bit of planning and good timing. However, one issue might be harder to avoid—and that’s the first one we’ll discuss:
While a lump sum offer may look like a lot of money initially, it’s important to consider the effects of inflation. Once you receive that payment, it becomes cash. Inflation erodes the value of money over time. So, while that large amount might help you create a sustainable annual budget for the first few years, your money might not stretch as far a decade or two later.
The best way to avoid inflation erosion is to reinvest as much as possible (even in your later years). Low-risk, slow-growth investments can help your money outpace the inflation rate during your retirement.
The most important skill to have when receiving a lump sum? Restraint!
Lump sum payments can be hundreds of thousands of dollars, if not more. If you have big eyes, it might be difficult to imagine how quickly that money can disappear. Without regular payments, overspending is a genuine concern that could empty your bank account in just a few years.
When choosing the lump sum, creating a lifestyle budget is a good idea. This can help you determine how much money you need for bills, medical care, travel, entertainment, etc. It also lets you see where you can stand to save money.
With a budget, you could set an annual allowance that can help stretch your money over the next 20 years or more. That’s why creating a financial guide is one of our retirement mastery principles.
As we’ve seen over the last year, interest rates can affect us in many ways. This includes pension payments.
As I mentioned above, interest rates are used to calculate the value of your pension. High interest rates result in lower pension payments; low interest results in higher payments.
However, interest rates can fluctuate month-to-month. To avoid these fluctuations in pension payouts, companies typically use a set interest rate to calculate pension values for the entire year. This is usually one month’s interest rate. For instance, a company might use October’s rate as their guideline. They’ll use that rate for the year, then recalculate the following October.
So, timing can be an essential factor in your pension’s value.
Consider the way interest rose between October 2021 and October 2022. 2021’s rate was comparatively low, meaning your pension payout would be higher. Even though interest grew steadily throughout the year, you could still receive this higher payout if you opted for it before they recalculated the interest.
However, if you waited until after October 2022 to retire and choose the lump sum, you’d be locked into a higher interest rate and a lower pension payment.
Are there taxes on lump sum pension payouts?
Like most other retirement distributions, pension lump sum payments are considered ordinary income and subject to federal and state taxes.
To cover these taxes, the company paying your lump sum will withhold 20% of your total payment. This works the same way taxes come out of your regular paycheck: it comes out automatically and goes toward the taxes you owe. At the end of the year, if it wasn’t enough, you’ll owe more. If it was an overpayment, you’ll receive a tax refund.
It’s important to note that the size of a lump sum payout will likely push you into a higher tax bracket. This means some of your income will be taxed at a higher rate than what you’re used to.
However, these tax burdens can be avoided by performing a rollover.
Can I roll over my lump sum payout?
Yes, you can roll your pension payout into another retirement plan. This works the same way as performing a 401(k) rollover.
Once your pension gets paid out, you have 60 days to roll it into a qualified retirement plan. You can avoid the tax burden if you perform the rollover before this deadline. However, if you miss this deadline, the payout becomes taxable income. If you miss the deadline and are younger than 59 1/2 years old, it’s subject to an additional 10% early distribution penalty fee.
You have two rollover options:
- With a direct rollover, you can have your pension funds sent directly to your new plan. This is the easiest option, as it only requires contacting the company paying your pension to initiate the rollover. Provide them with the information on where to send your funds, and they’ll roll it over for you.
- An indirect rollover is one where you become the middleman. You receive a check for your lump sum payment, then send the money to your new retirement plan. However, the company paying your pension will only send you 80% of your total pension value and withhold the other 20% for taxes. You’ll need to roll over the entire value to avoid paying taxes. This means you’ll need to make up the final 20% yourself.
As always, a financial advisor can help you determine the best options for your specific needs and goals.