Weekend Read: Lump Sum vs Annuity – Making the Best Pension Choice
In the 1970’s companies began to transition from pensions to 401(k)s. The introduction of the 401(k) was originally designed to allow executives to receive a tax advantage for their profit-sharing plans. Over time however, many companies viewed it as a way to transfer the obligation/burden of a secure retirement from the employer to the employee1. Many people still have a pension benefit and thus the responsibility to decide how to take it. When you retire, your pension plan might give you a choice: take a lump sum distribution or receive monthly annuity payments. Each option has its own set of benefits and potential drawbacks, and the best choice depends on your personal circumstances and financial goals.
Lump Sum
Let’s start with the Lump Sum option. This gives you the money upfront, which means you have control over how it’s invested and how that income is distributed throughout retirement. Taking the lump sum and putting it in an IRA is not a taxable event. You would not pay taxes on it until you remove it from the IRA. A potential advantage here is the possibility to leave residual funds for your heirs.
On the tax side, receiving monthly annuity payments can increase your taxable income, which might impact how much of your Social Security is taxed and the size of your Medicare premiums. The lump sum gives you the option to move some of this money into a Roth IRA, eliminating the RMD requirement. This strategy is called a Roth Conversion and the money that you convert to Roth must have taxes paid up front. This can potentially reduce your taxes in retirement and allow the money to grow tax-free.
Life expectancy is also a key factor. If you have health concerns or a family history of shorter lifespans, taking a lump sum might be more attractive. This way, you can draw down the money more quickly while you're alive or potentially leave more to your spouse after you’re gone.
Annuity
Now, let’s talk about the Annuity option. With this, you receive a “guaranteed” monthly payment for life. You never see the principal; your employer manages it and distributes a paycheck to you every month, which you pay taxes on.
You typically have choices, like whether you want the payments to continue to your spouse after you pass. This spousal benefit usually means a reduced payout to you since the pension expects to pay it out longer. You’ll need to calculate if this is necessary based on your other income sources in retirement. If your spouse has their own pension or if you have sufficient assets, you might want to maximize your income during your life instead. In this case, there may be more tax-efficient places to take your income from than a mandatory monthly distribution that creates a taxable event.
Since the annuity option means you are receiving a payment every month, this means your will have taxable income from these distributions . This isn’t necessarily a problem, but it does remove the option of controlling how and when that income is distributed.
Making the Decision
Deciding between a lump sum and an annuity is something I often help people with by running two scenarios side by side. This way, you can see the differences over time and figure out which option you prefer. For some, leaving a nest egg for their heirs is a top priority, even if the annuity math is slightly better. For others, they have enough income from social security and taxable accounts that the annuity income would create an unwanted taxable event. These are the types of considerations we need to weigh when deciding which option makes the most sense for you.
If you have any questions or need help figuring out which option is best for your situation, feel free to reach out. I'm always here to help!
1http://benna401k.com/401k-history.html
Individuals are encouraged to consult their tax and legal advisors (a) before establishing a Retirement Account, and (b) regarding any potential tax, ERISA and related consequences of any investments or other transactions made with respect to a Retirement Account. Tax laws are complex and subject to change. Steward Partners does not provide tax or legal advice.
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