As retirement gets closer, you may be thinking about how you want to handle your pension plan. While taking a lump sum payment to get all that cash at once may seem tempting, there are several factors to consider. Before making a final decision, it helps to weigh all your options since you can't change your mind later.
Considering the Financial Implications
If you take a lump sum payment when you retire, you give up receiving a guaranteed income each month. You won't have to worry about outliving your retirement income, but if it's a pension plan that offers fixed payments, inflation will eventually eat into your monthly benefit. With an average annual inflation rate of 3 percent, in just 10 years, your monthly pension check could take a big hit in buying power.
If you're good at managing money, taking a lump sum payment may look like the more attractive option. You will lose some of the money up front since the law requires the employer to withhold 20 percent of the payout amount for federal income taxes.
If you take the payout before you reach the age of 55, you will owe the IRS another 10 percent in early-withdrawal penalties. But you can save tax dollars by rolling the money you get in a lump sum into an IRA. That way, you only have to pay taxes on the amount you withdraw each month.
Taking a lump sum may also be a good idea if you're looking to invest a chunk of money short term. With a lump sum of cash at your disposal, you may want to invest more aggressively. Although higher-return investments are riskier, there is the potential for making more money that will last you longer into your retirement years.
Playing Both Sides of the Fence
If you decide to take only a partial lump-sum distribution, it will give you cash in hand plus a monthly annuity payment. Although taking part of the money in a lump sum will decrease the amount of the annuity payments you receive each month, it will give you money to pay off your mortgage or other debts you may still have when you retire.
But the same as if you take a full lump-sum distribution, a partial distribution will reduce your monthly benefit. In addition, if you don't roll the portion of the lump-sum distribution you elect to take into an IRA, the plan administrator will withhold 20 percent of that amount for taxes.
Factoring a Spouse in the Equation
If you're married, you may not be able to take a lump sum payment unless your spouse signs paperwork waiving spousal rights to a survivor benefit. Pension plans offer retirees the choice of a monthly payment based on their expected life span, or a smaller monthly benefit that will continue until the retiree's spouse dies.
If you die first, depending on the terms of your pension plan, your spouse will either receive the full pension benefit or half of what you received.
Divorce makes no difference. Under federal law, even if you and your spouse get divorced years before you retire, pension benefits you earned while you were married are marital assets to which your ex-spouse may be entitled. Your ex must ask the court for a share of your benefits at the time you divorce, not at the time you retire.
Usually, a defined benefit pension plan will not make a lump sum cash payment as part of a qualified domestic relations order (QDRO). The plan pays benefits monthly.