Traditionally, employees who took part in an employer-sponsored retirement plan, or pension, had just two choices when it came to disbursement: a lump-sum payout or a monthly pension/annuity. Recently, the Internal Revenue Service (IRS) and the Treasury Department helped create a third option, allowing retirees to blend the two previous choices into one. According to a recent article from MarketWatch, those who choose to adopt the new rules can offer their workers a chance to take distributions partially as a monthly pension and partially as a lump-sum payment.
“The IRS released these regulations because it found that the current rules encouraged individuals to choose a lump-sum option, rather than the lifetime annuity option that would protect against the risk of outliving retirement savings,” said Robert Bloink, a law professor at Texas A&M and William Byrnes, an executive law professor and associate dean for special projects at Texas A&M in a trade publication.
While there are more choices available when retiring, employees still have an important decision to make. Here are some points to consider when determining which disbursement is right for you.
The need for guaranteed lifetime income
A large number of industry experts recommend using guaranteed lifetime income (i.e. Social Security and annuities) to pay for any essential living expenses in retirement. Any additional assets can be used for discretionary spending. To help determine how much of your employer-sponsored retirement plan to take as an annuity and how much to take as a lump sum, calculate your essential retirement expenses (housing, health care, food, etc) and then calculate how much guaranteed lifetime income you’ll receive from Social Security and other lifetime sources. If there’s a gap, consider taking a monthly pension in an amount that covers it.
For example, if you have $4,000 a month in essential expenses and $3,000 a month in guaranteed income, you should look to take a partial annuity of $1,000 a month, and the rest as a lump sum. If your guaranteed income is greater than your essential expenses, consider taking a smaller monthly pension, on none at all.
“For many people, taking a partial lump sum and a partial annuity distribution will be a very good choice,” said Anna Rappaport, president of Anna Rappaport Consulting. “Society of Actuaries research shows that many people do not consider irregular and unpredictable expenses in planning. Even expenses like home repairs and dental that are expected, but the timing and amounts are uncertain, are often not planned for.”
Money management skills
Historically, if a retiree was looking to manage their own money, the lump-sum option made the most sense. But if confidence in money management skills was shaky, the pension was the wise choice. There was no middle ground. Now, the level of responsibility is flexible.
“Ultimately, the choice between taking a lump sum or annuity — or combination of the two — should center upon the individual’s desire and ability to control the pension funds,” said Bloink. “The key question to ask is how the worker will reinvest a lump sum and manage the funds in the future.”
The tax situation
One of the top goals in retirement should always be to create the most tax-efficient stream of income. In order to do that, you’ll need to run some “what-if” scenarios that estimate what your tax bills will look like over time, considering the lump sum, the monthly pension, or a mix of the two. Income tax professionals should be able to help you with this process. Using their tax software programs, you should be able to see which options provide the most after-tax income. “Rolling the funds into an IRA can help the individual avoid current taxation on the lump sum,” added Bloink.
Other factors to consider include your life expectancy and the perceived health of the pension. “If the individual or the pension is unhealthy, this should cause the worker to lean toward the lump sum (or combination lump sum-annuity) option,” Bloink stated. “If the worker is relatively young and healthy, he or she should consider the security that an annuity stream can offer for life.”
If uncomfortable with the pension’s stability, compare the cost of purchasing a commercial annuity with the lump-sum amount. “The inflation protection and indexing options that are typically available in a commercial annuity, but not in a pension-managed annuity, should also be considered,” he added.
According to data, the common retirement strategy of taking Social Security and a corporate pension right at retirement is usually not the wisest.
“A better strategy would be to cash out some or all of the corporate pension and use the proceeds to defer Social Security,” said Jason Scott, managing director of the Retiree Research Center at Financial Engines. “This is true for many people, and definitely the case for a married person who is the high wage earner in the household.”
Instead, Scott offered the following strategy:
- Use a Social Security planner to get a claiming strategy that maximizes lifetime Social Security payments.
- It is often recommended to defer Social Security. “If funding the deferral is not financially feasible, consider working longer or taking a partial lump sum cash out from your pension to fund the deferral,” Scott stated.
With this approach, you can typically create higher total monthly payments as well as have cash left over from the lump-sum distribution. “Not too bad,” said Scott.
Written by Rachel Summit