- Lump-sum payments are one-time pension payouts. If you take this option, you will get all of your pension upfront in one single payment.
- Regular pension payments, or annuities, are typically made every month. Depending on your pension, they may be subject to cost-of-living increases.
- There are upsides and downsides to lump-sum pension payments, and both have to do with the fact that you get all of your money up front.
The difference between lump-sum vs. regular pension payments, or annuities, is a question of time. If you take the first option, you get all of your money now. If you take the second option, you get regular payments on a fixed schedule, typically every month.
If you’re wondering whether it’s better to take a lump-sum pension payment or annuities, the answer will depend on several factors. As we will see, there’s a complex tradeoff to consider. If you take all of your money up front, you gain the freedom to decide what to do with it, but you also gain the risk, a potentially greater tax liability, and you forego the possibility of a greater total payout over a longer period of time, particularly with cost of living adjustments (COLAs).
Of course, the question of which option is right for you personally will ultimately depend on your own preference. However, it’s a good idea to talk to a Certified Financial Planner® to make sure that you are aware of all of your options, as well as the costs and benefits of each of those options.
What are lump-sum payments?
Lump-sum payments (sometimes called clump sums) are one-time pension payments. If you take this option, you will receive a pension lump sum payout from your pension administrator.
If you’re wondering how to calculate a pension lump sum, you’ll need to look at how much you and your employer (if applicable) have been contributing and over how many years. You’ll also want to talk to your pension administrator, because the way in which you have invested your pension will affect the ultimate amount of the lump sum payout.
The benefit of taking a lump sum payment is clear: it’s a way of getting all of your money at once. You can then decide what you want to do with it.
Of course, pension income is taxable, so pension lump sum tax rules apply. The IRS lists five different options for treating the portion of a lump-sum distribution attributable to your own active participation in the plan:
- Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and the taxable part of the distribution from participation after 1973 as ordinary income.
- Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and use the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).
- Use the 10-year tax option to figure the tax on the total taxable amount (if you qualify).
- Roll over all or part of the distribution. No tax is currently due on the part rolled over. Report any part not rolled over as ordinary income.
- Report the entire taxable part as ordinary income.
Before you decide to take your pension as a lump sum, it’s a good idea to talk to a Certified Financial Planner® to advise you on your options. Depending on your situation, your wishes, and your priorities, you may or may not end up favoring this method of disbursement.
What are regular pension payments?
Regular pension payments, or annuities, are set payments to the beneficiary. These payments are typically made every month.
How long does a pension last? The answer is that if you select this option, you will receive payments from your pension administrator every month for the rest of your life. In some cases, depending on your pension plan and your benefit elections, if you are survived by your spouse, they may be able to receive further payments for the rest of their life.
How much is a pension worth? The answer will depend on several factors, including how much you have put in, and how you have chosen to invest it.
Some pensions also have cost-of-living adjustments (COLAs), meaning that the set monthly payment may actually increase over time. Typically, these increases are indexed to inflation.
Upside & downside to lump-sum payments
If you’re wondering whether to take a lump-sum or annuity for your pension, it’s a good idea to consider both the upsides and the downsides of pension lump-sum payouts.
We’ve already covered one significant upside to pension lump-sum payouts: you get the money now, all of it, in one single payment.
To do this point justice, it’s important to understand the trade-off you’re making. If you opt for all of your money up front, you will have more control up front. One benefit of this is that you get to choose how to invest that money and what to do with it. Another benefit is that you will not have to worry about the possibility of your company going broke and not being able to pay out on your pension.
How long does a pension last? Part of the answer depends on how long the pension administrator lasts – but if you take all of your pension in one lump sum, you won’t have to worry about this particular risk. If you have talked with a Certified Financial Planner® and have a clear idea about what you want to do with your money and how you want to invest it, you may end up deciding that the benefits of taking a lump sum payment outweigh the downsides.
With all of this said, the downsides of taking a lump-sum payment are similar to the upsides. In many ways, they are the other side of the coin.
For one thing, because you receive all of your money from the pension in one lump-sum payment, and that means you assume all of the risk for how you will invest it. Of course, you can mitigate the risk by talking with a Certified Financial Planner®. Depending on your situation and your options, one thing to consider is the possibility that a lump sum payment might push you into a higher tax bracket.
Some people prefer to roll lump sum pension payments into another vehicle for investment, such as an IRA. Doing this will give you more control of when you remove the funds and pay income tax on them, although you will have to start taking required minimum distributions (RMDs) beginning at age 72. A Certified Financial Planner® can help you to figure out whether or not this option could improve your tax situation.
Another downside of taking all of your pension as a lump sum payment is that you will miss out on any COLAs. If your pension is subject to COLAs, part of the tradeoff of taking a lump sum payment is that you will forfeit the possibility of receiving a greater total sum of money over a longer period of time. Likewise, if you take your pension as a lump sum, it's your job along with your financial professional to monitor and create an income plan. Periodic pension payments are valuable in the sense that they create a steady "retirement paycheck". In the lump-sum option, you have to ensure you're not spending down that lump sum too fast to risk running out of money later in retirement.
Of course, there is also the possibility that even apart from the question of COLAs, taking your pension as annuities would yield a greater total amount. As we have seen, this possible benefit should also be weighed against the possibility of your pension fund becoming insolvent. In essence, taking a lump sum payment takes away that insolvency risk and transfers the risk of investment to you personally.
Whatever your plans for retirement, whatever your financial situation is, it’s a good idea to talk to a Certified Financial Planner® before you make the decision to take your pension as a lump sum or annuity. The question of lump sum vs. annuity is a complex tradeoff, one that involves several factors.
You’ll want to think about your own cost of living, your interest in investment, your risk tolerance, and the tax ramifications of any option you are considering. For some people, taking an annuity or rolling a pension over into an IRA may make far more sense and be far more appealing than a lump sum payment. On the other hand, you may decide that you are willing to accept the risks of investment and you want your money now.
The decision you make will affect your own retirement and will likely have ramifications for any heirs you may wish to leave money to. For all of these reasons, it’s a good idea to talk to a Certified Financial Planner® to evaluate your options and the costs and benefits of each tradeoff.