Many of you will contemplate retirement this year and despite what the news is telling you, if you have a pension plan sometimes referred to as a defined benefit plan at your current employer, this could be a great time to retire. Most pension/defined benefit plans give you the option of taking a series of lifetime monthly payments or a one time lump sum cash payment. This is not a decision to take lightly or a decision to make quickly. This decision will affect you and your family for decades and even generations to come. And it has tax implications!
Annuity or lump sum?
Let's look at an example:
John has worked for his cooperative/company for 40 years. He does have a pension/defined benefit plan available to him. His choices are:
1. take a single lump sum cash payment of $1,800,000
2. take a series of monthly payments, sometimes referred to as the annuity option as indicated on the table below:
Typically, the plan administrator will briefly explain the options to you but offer no advice as to which is the better decision for you. They don't offer advice because legally they can't.
What are you supposed to do? What should you do? Who understands all these annuity options anyway? If you need help seeing the explanation of these annuity options in plain English, click here.
Two important things to consider before making this decision
Current income needs- Do you need all of that monthly income right now?
Tax implications- Here is the one thing I find people don't consider when making this decision. If you take the monthly payments you will pay income tax on that money. Say that in the example above John took the Life Only option with the COLA (Cost of Living Adjustment. A COLA increases the amount of monthly payments each year according to inflation) so he would receive $8,040.27 per month which is approximately $96,000 per year. If John is single he will get a standard deduction on his federal taxes of $12,950. He will pay income tax on $83,000 of those dollars which puts John in the 22% tax bracket his first year of retirement. He will now pay approximately $15,000 in federal taxes every single year.
What if John only needed $4,000/month to live comfortably because he was debt free and he also had a monthly Social Security amount of $30,000 per year? In this case John could have elected to take the lump sum payment of $1,800,000 and rolled that over into an IRA (Individual Retirement Account) with no taxes owed until he starts withdrawing the money. He only needs $4,000 per month which is $48,000 per year. John is now in the 12% tax bracket and pays approximately $4,000 in federal taxes each year. That's a savings of $11,000 each year that he is not paying in federal taxes!
Remember that if you opt for a lump sum payout and don’t roll it over, you’ll pay taxes on the entire amount in the year that it was paid to you. That would put John in the 37% tax bracket which makes this advisor feel nauseous just thinking about that.
Other things to consider
Health-If you choose an annuity, you’re choosing a lifetime cash flow. If you choose a lump sum you generally will have more control over the asset, but not the promise of a lifetime cash flow. Balance annuity payments with other savings and resources. If you have a single, large expense like a health-care event, you may need money to pay for large expenses or bills in excess of Social Security and annuity payments.
Risk-Ask yourself how much of your retirement income will depend on markets and how much is insured (e.g. provided from Social Security, pension or annuity)? Do you feel comfortable with this balance? If not, consider the annuity. If so, consider the lump sum.
Inflation-Unless the annuity payment carries a cost-of-living adjustment, you’ll lose purchasing power over time. A lump sum could be invested to include a prudent allocation of equities to help assets have a better chance of keeping up with inflation.
Do you want to leave an inheritance-Unless you choose a term certain or survivor benefit option, your annuity payments die when you die. A lump sum could be passed on to your heirs, your church, your spouse, etc. Be sure to factor your gift and estate planning goals into any lump sum versus annuity decision, along with the additional factors above.
What we believe
In life we often worry about many decisions from day to day. Most of those decisions honestly don't matter all that much because if we make the wrong decision we can usually correct it. It might take some money and some work but most bad decisions are fixable.
However, that's not the case in this matter. Once you make this choice it's final!!! You can't undo this decision. You can't change your mind.
There are cases where the monthly pension offer is the better choice and we can show you how to determine this. There are cases where the lump sum offer is the better choice and we can show you how to determine this also.
The key word is control. With the lump sum option you have complete control of your money for the rest of your life and possibly your heirs lives, too. You control your monthly income, you control your taxes, you control your investments and you control the retirement that you worked so hard to get to.
Talk to an advisor before you make this decision. We recommend you talk to numerous advisors and work with the one you feel comfortable with. If that's us, great. If that's not us, that's great too, but please talk to someone other than your well-intentioned friends and relatives.
You need a plan
A goal of retiring - without a plan - is simply a plan to run out of money. At 80/20 Financial Services our specialty is retirement planning for electric cooperative retirees and retirees in general.
We help our clients increase their income, manage their investments, protect their assets and decrease their taxes.
Contact us to set up a consultation. The consultation is free and without obligation.
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80/20 Financial Services is an Independent Registered Investment Advisor (RIA) registered in the state of Missouri (CRD# 300772). We help clients in Missouri and throughout the United States prosper in retirement. Being independent allows us to work exclusively for YOU.
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