Traditional defined-benefit pension plans have become fairly rare in recent years, but there are still a good number of people who have them nonetheless. They can get a bit complicated when you leave an employer where you have a plan. Employers often give departing employees several options, including taking a lump sum distribution.
I received a question on this topic recently, and it's a good starting point to open up the discussion:
“My former employer is giving me the option to receive a lump sum payment for my pension. I need some advice on which account to put my money in for my retirement. I currently work and my employer has a 401(k) plan for retirement. I need advice on roll over for this lump sum payment.”
I'm assuming that the writer is over age 59 1/2, but the information provided will also apply if you’re younger.
One Pension – But Many Options
Typically, when you leave an employer that offers a traditional pension plan, you're given several options as to how to handle the proceeds:
- Leave the funds in the pension plan, and begin receiving payments at retirement
- Take a full distribution and do a rollover into a new employer plan
- Take a full distribution and do a rollover into an IRA
- Take a full distribution and use the money for current needs
- Set up a “series of substantially equal payments” beginning immediately
#1 is self-explanatory. You leave the money in the pension plan, and when you reach retirement age you begin receiving monthly payments. The attraction of this option is that you don't have to do anything. But that doesn't mean it's the best option either.
The problem with traditional pensions is that you never really know what's happening with them. For example, you don't know what they're being invested in or what the return is. You go with the assumption that your former employer has it all under control, and all is well.
If you aren't comfortable with that outcome, you still have four more options, and they fall into two basic categories.
Lump Sum vs. Lifetime Payout
Options 2, 3 and 4 all deal with taking a lump sum distribution from the plan, but each results in a different outcome. # 5 involves setting up a lifetime payout.
Let's try to sort out which of the two – taking a lump sum, or setting up a lifetime payout – will be the best option for you and your personal situation.
Taking a lump sum distribution is an attractive option; after all, it gives you control over what is likely a large amount of money.
But before jumping into what seems to be the obvious choice, you need to seriously consider your personal situation as well as your own ability to handle a large lump sum of money. In the end you might decide that setting up a lifetime payout is the better option.
Let's look at the pros and cons of both taking a lump sum distribution (we'll consider the three options available later on) and a lifetime payout.
Lump Sum Pros and Cons
The pros of taking a lump sum distribution:
Getting a better return on your money than your pension will provide. If you take a full distribution of the money in your old employer pension plan, you will be able to invest it using self-directed options. This will open up the possibility of getting a higher rate of return on your pension money, providing you with an even larger nest later on.
This can be even more important if you take the lump sum early in life, such as when you have another 20 or 30 years to go before you retire. In that space of time, you can grow the money to three, four, or five times the value at the time of distribution.
Greater investment diversity. If you already have other investments, such as IRAs and regular taxable accounts, taking a lump sum distribution from your pension can give you an opportunity to spread your investment activities into different accounts and different asset classes.
For example, while most of your IRA money may be invested in growth stocks, and your taxable investments in low yielding interest-bearing investments (for liquidity), you may decide to take the pension money and invest it in other types of assets, such as real estate investment trusts and high-yield dividend stocks. Diversification can protect your overall investment worth from different types of market conditions.
Roth IRA conversion. Distributions from traditional pension plans are eligible for Roth IRA conversions. You can roll the pension money over to a Roth IRA – and pay ordinary income tax on the amount of the rollover – and create a tax-free income for your retirement.
A Roth IRA enables you to take tax-free withdrawals of both your contributions (and conversion amounts), as well as the investment income earned on them, tax-free as long as you have been in the plan for at least five years, and are at least 59 1/2 years old. That can provide the kind of income tax diversification in retirement that you could never get from a pension.
You can use the money for an important current need. Life has a way of throwing circumstances at us that can upset our best laid plans, and create a sudden need for a lot of additional cash. Though taking money out of a pension plan is never a perfect idea (because of the income tax consequences) there are situations where it may be necessary.
For example, you or your family may be facing a pressing medical situation. Even if you have decent health insurance, you can still face deductibles and uncovered procedures and therapies that can cost you tens of thousands of dollars. The medical expense deduction that you can take on your income tax return may even offset part or all of the pension distribution tax liability.
The cons of taking a lump sum distribution:
You could end up blowing the money. Unfortunately, there's no more polite way to put it. I've even seen this happen. For example, I had a client who wanted to buy a brand new full-sized truck with his pension rollover. It was a $70,000 truck, and that was before taxes! That's a pretty serious amount of money, especially when you consider that it was money that was intended for retirement.
You could create a tax liability. There are of course ways to get around having to pay income tax on a lump sum distribution. But if you take the money and use it for current spending, the full amount of the distribution will be subject to ordinary income tax.
And that's not all. If the distribution occurs before you reach age 59 1/2, the full amount will also be subject to the IRS 10% early withdrawal penalty. If you are already in a high tax bracket (remember to include your state income tax rate), you could pay 50% or more of the distribution in taxes. And if you don't know that while you’re spending the money, you could be unknowingly creating a financial disaster for yourself.
You may underestimate your need for additional income. Sometimes in the rush to get your hands on a large amount of money, it's easy to forget about the need for income. For example, if you’re taking the distribution and using it to pay for current expenses, what will happen in a few years when the money's all gone?
More from GFC, Below
Before taking pension money in a lump sum, first evaluate the sources and stability of the income that you and your spouse already have. This includes employment income, Social Security, investment income, and other retirement income. Unless you have enough income from these sources, you may want to use the pension distribution to create yet another income.
Inability to successfully invest the money on your own. Not everyone is skilled at investing money. If you’re not, then there’s a major risk that you won't do as well in managing the money as the pension manager will. Worse, there’s great potential to lose money investing.
A lack of other assets. The decision to take a lump sum should be considered in light of other assets that you have. For example, if you have other retirement accounts and/or taxable accounts, that have a substantial amount of money, you will be in a better position to take a lump sum from your pension.
Lifetime Payout Pros and Cons
The pros of taking a lifetime payout:
Providing yourself with a guaranteed income. Setting up a lifetime payout can provide you with a fixed income level, literally for the rest of your life. This can be an important supplement in retirement, but it can also provide a necessary extra income in the years leading up to retirement, when you might be either under-employed or even disabled.
Income diversification. Whether a lifetime payout begins when you are retired or when you are still working, it will represent an additional source of income. That will provide you with a strong measure of income diversification. That means that you will no longer be relying completely on the income from a job or from Social Security.
And if you are retired, it could help to prevent the need to take distributions from your other retirement savings. That means that those plans, like IRAs, can continue to grow to be used later on in your life. That will provide you with a good strategy to prevent outliving your money.
No chance to lose money investing. Since traditional pension plans are defined-benefit plans, you will receive the stipulated monthly income from the plan. That means that you will not have to worry about funding the account, or about investment performance. You'll get your monthly payment no matter what happens.
It's also something of a spendthrift provision, since it will also keep you from getting early access to the money. That will help to ensure that the money is there for the rest of your life, and won’t be drained by either an emergency situation or an error or in judgment.
The cons of taking a lifetime payout:
The income may be very small. Since an early payout from a pension plan is based on your remaining life expectancy, monthly payments may be much smaller than you anticipate. For example, if a plan has $100,000 and you have a life expectancy of 25 years, monthly payment may be only around $300 or $400 per month. That's a modest car payment, and not much else.
The situation is even more extreme if you set up a lifetime payout earlier in life, for example at age 50 or 55. Based on a life expectancy of 35 years, your monthly benefit may be only around $200 per month. That may help in some small way, but it will hardly be life-changing.
No opportunity to grow the money. Once you set up a lifetime payout arrangement, financial parameters of the plan are pretty much set. You will not have an opportunity to invest and grow the funds so that you will have a larger portfolio and a higher income in retirement.
This is even more important because where retirement is concerned, you have to take inflation into account. The $300 per month payment that you’ll get under the payout arrangement will be even smaller in ten, 20 or 30 years. That's the downside of a fixed monthly payment.
No access to the money for important current needs. If at some point during your life you do need extra money to cover an emergency expense, you will not be able to access the money in your pension plan under a lifetime payout arrangement.
This will be an especially unfortunate situation if the pension plan funds represent most of the money that you have. The income will be there for the rest of your life, but you won't be able to touch the principal balance of your money.
Lump Sum Options
If you do decide to take a lump sum distribution from the pension, you have at least three options:
Take a full distribution and do a rollover into a new employer plan The writer mentions that he is with a new employer, and has a 401(k) plan there. He can roll his pension plan over into that 401(k) plan, as long as his new employer permits it. There will be no tax consequences for the rollover, and the pension money will remain available for its intended purpose of retirement.
Take a full distribution and do a rollover into an IRA. Let's assume that there is no new employer plan to roll the pension over into. You can still roll the money over into an IRA account. And as I discussed earlier, you can also do a Roth IRA conversion, which will set the money up to provide tax-free income in retirement.
Take a full distribution and use the money for current needs. This should only be considered if you have a substantial emergency that you need the money for, and don't have any other sources of cash. Still, you will likely have some sort of tax liability, and may even be subject to the 10% early withdrawal penalty.
Lifetime Payout Options
The writer didn’t indicate his age, but if he has reached the age of retirement specified in his former employer’s pension plan, he can simply begin taking monthly retirement benefit payments now.
If he had not reached retirement age, he can then set up what is known as a ”series of substantially equal payments”, which would begin to provide him with monthly income payments immediately, and for the rest of his life.
Technically speaking, this is referred to as a 72(t) distribution. Essentially what it does is to enable the distribution of a pension plan on an annual basis, based on your life expectancy. For example, if you're 50 years old, and your life expectancy is 85, the pension can be paid out over 35 years.
There'll be ordinary income tax on the distributions, but not an early withdrawal penalty. It’s a way that will enable you to access your pension money immediately, and without being penalized.
Any Option Should be Part of a Comprehensive Financial Plan
Whether you choose to take a lump sum distribution, or set up a lifetime payout arrangement, it should be set up as part of your overall financial plan.
When you're considering which direction to take, you have to evaluate other financial aspects of your life, including your income, your savings and investments, your debt level, your income – both the amount and reliability – as well as your ability to save and invest money.
Any major financial transaction, including and especially the disposition of a pension plan, always has to be considered against the backdrop of your complete financial picture, as well as your future plans. Only then can you know for sure if it will be in your best interest to either take a lump sum or to set up lifetime payouts.
And if you're still unsure, it's time to talk to a financial planner.