Article summary: Should I take my pension as an annuity in retirement where I receive monthly payments or take a lump sum that I rollover into an IRA account and manage the investments myself? Answer : It depends on whether you can invest the money better than the returns you would get from your unadjusted annuity payments.
My former company is one of the few that actually provides a pension plan and after five years or service you become eligible (or vested) for receiving a pension. So when I resigned from my company after seven years of service I had to decide what to do with my pension. Based on a letter from my company’s pension plan administrator I had the option to take the pension as a one-time lump sum payment or get it as a traditional pension in the form of a lifetime monthly benefit (i.e. a life annuity option)
Annuity 101 – You can see this article for more on annuities. But essentially a life annuity used in pension plans pays a guaranteed amount every month for the rest of your life. But a big point to note is that the monthly payments from a pension/life annuity aren’t generally adjusted to inflation so if I were to retire in 20 years the value of the pension payment in real terms would be much less.
For my decision I am assuming the use of a single life annuity. Though if you were married you would need to look at a 50% or 75% survivor annuity (known as a spouse or joint annuity option) payout. The monthly payout for a spouse annuity is much lower but the benefit is that the spouse gets the annuity even after the participant dies. In a single life annuity the benefit ends at death for the recipient.
Here are some key figures that I needed to make a choice. You can get these numbers from your plan administrator when you are sent the pension payout details, but you’ll have to go through a lot of legal boilerplate material before you find the information. But it is really the key information you need to make an objective decision.
Monthly Pension Benefit Payable at normal retirement date (single life annuity) = $748.74
PV of Benefit = $29,806 (this is the Lump Sum Amount you would receive today)
Number of months to retirement = 339
Based on the above you can derive the interest rate (or rate of return) used. If you feel you can generate a better average return than this by investing yourself then take the lump sum. Otherwise stick with the annuity option. To figure the rate of return, use the RATE formula in Excel and enter the above variables. The formula I entered was “=RATE (339, 748.74, -29806,0)“ and the outputted rate was 2.51%. This is the rate used to derive the annuity payments, which you can think of as the rate of return.
Because I think I can generate a better investment return than 2.51% I chose the lump sum option, which I will rollover into an IRA to avoid a big tax payment now. If I were to invest and generate a not so unreasonable average nominal return of 8% over the next 20 years, I would have $138,925 at retirement which would give me a monthly payment of around $1,179 that would last 20 years. Much more than the $748 I would get through the single life annuity monthly payment.
Some key items to keep in mind with pension lump sum payments into an IRA or other qualified retirement account:
- Tax impacts of lump-sum vs rollover. While you can take the lump sum as direct cash payment, it will generally count as taxable income in the year you take it unless you move into an IRA account, in which case taxes are differed until withdrawals made after retirement. A cash lump sum payment may also be subject to an excise or penalty tax. So unless you really need the money, rolling your lump sum payment into an IRA account is a no-brainer.
- If you are married then you must obtain your spouse’s consent for any transaction involving the lump sum pension amount
- In my research for this article I found some plans that allow you to take a combination of an annuity and lump sum. This may be a good choice if available as you get the flexibility of a lump sum but the more certain nature of a lifetime pension payment
- The Pension Plan rollover into my IRA account will NOT be subject to the annual contribution limits that these retirement plans are normally subject to because you are just moving funds from one retirement source to another. Also just in case you thought you could, you cannot claim the pension lump sum rolled over into an IRA as a deduction against your ordinary income like you do with normal qualified IRA contributions.
Actually moving the lump sum payment directly from the pension plan to a qualified IRA account will take some time and requires a bit of paperwork. You need to first setup a IRA account (here is a list of good brokers) and then ask the company you set your IRA up with to mail you a letter confirming that you are enrolled int a qualified IRA plan with them. You need this letter, along with the rollover forms that your pension plan provider should have sent you, to actually process the rollover. The whole thing took me about 3-4 weeks after a month of procrastination.
One last item to note is that you doesn’t need to rush into making a decision, despite what your company’s pension plan notice may indicate. Even if you decide to go with the traditional pension plan option to receive an annuity you can elect to do what’s called an In Service Distribution that allows you to roll over your pension amount into an IRA when you are eligible to officially retire at 59 ½.
My choice to go with a lump sum distribution into an IRA account is driven by the fact that I feel I can manage the amount myself and its not a huge amount. As a rule of thumb to make the choice the younger you are, the better the lump sum rollover to IRA option. If you have been vested in the pension plan for a long time and so have a relatively large guaranteed monthly benefit (>20yrs) or you just want the certainty then the better the annuity option is for you.
However there are many life factors to consider and everyone has different circumstances. So in addition to the items I have discussed above I suggest meeting with professional (CPA or CFP) to help decide which option is best for you over the long term.