Pension lump sum considerations
Factors that can help determine if a lump sum may be right for you include retirement savings, pension lump sum tax rules and life expectancy.
Pensions provide a guaranteed lifetime income at retirement and, if elected, an income to your surviving spouse. However, there may be situations where taking a lump sum payment is more beneficial. Each person's situation is unique, but here are some general factors you’ll want to consider as you weigh your options.
Retirement savings
It may sound attractive to take a lump sum payment and use it to travel or to pay off debt but consider whether you’ll have enough money to live on long-term.
The first thing you’ll want to consider is the amount of money in your retirement savings. Is it enough to live on in your retirement years? What other income streams may be available to you? Do you plan to get a part time job? Do you plan to turn your lifelong hobby into a business?
Pension lump sum tax rules
Next, you’ll want to consider how the tax consequences might affect your decision.
Income tax
All money received from a pension is taxed as ordinary income, regardless if you receive monthly payments or take it as a lump sum. Whether you get taxed immediately upon taking the lump sum, or taxed later, depends on what you do with the money when you receive it.
- Taxed immediately: If the money isn't rolled over into a tax-deferred account, you'll pay ordinary income tax on the amount of the lump sum when you receive it.
- Taxed later: If the money is rolled over into an Individual Retirement Account (IRA), you won’t be taxed at that time; however, any distributions from the IRA will be taxed as ordinary income.
Estate tax
Your decision to take a lump sum payment affects whether or not your pension will be included as part of your taxable estate.
- Excluded from estate tax: Pension payments will not be included in your taxable estate if the income payments stop at your or your spouse's death.
- Included in estate tax: With the lump sum option, the remaining value of the account will be included in your estate tax.
Life expectancy
Consider how many years you expect to live.
If you’re in ill health or have a family history of a short life expectancy, taking a lump sum may be an attractive option. However, there’s a risk you may outlive the funds, depending on the investment performance and how much is needed for income.
You can't outlive the pension income. If you’re in relatively good health and anticipate having many years left, it may be more beneficial to consider taking the pension payments.
How much money are we talking?
The earlier you are in your career and/or tenure with the company, the smaller your pension lump sum offer might be — if it’s a trivial amount; you may want to consider taking the lump sum offer and investing it for your future.
How are your money-management skills?
Pensions provide a guaranteed fixed income stream, and your employer assumes the investment risk when making defined benefit pension payments. When you take a lump sum, you assume the risk of investing the funds to generate retirement income.
Fluctuations in the market and changes in interest rates can have an impact on the future value of the lump sum and your available income. Consider if you are willing to take the risk.
What’s the plan for your legacy?
With pension income, generally nothing remains for your heirs after you and your spouse pass away (unless you elected your pension over a certain period of years).
With the lump sum amount, any remaining funds can be used to leave a legacy to your heirs or even a favorite charity.
Consult with a professional
A financial professional can help discuss your options as you decide what’s best for you.
