While many employers offer 401(k)s or similar retirement plans, some companies still sponsor defined benefit pensions. Your employer funds your account, and you're guaranteed a specific amount of income in retirement. Pension funds can be expensive to maintain, and employers may decide to freeze them to reduce costs. If your pension plan is frozen, you may be given the option of receiving your benefits as a lump-sum payment before you retire.
Frozen Pension Plan
When a company decides to freeze a pension fund, it means no new contributions to the plan are allowed. It's up to the employer to decide which employees will be affected. For example, a soft freeze may only apply to new hires or workers who aren't yet eligible to participate in the pension plan. With a hard freeze, you keep your existing benefits, but you won't accrue any additional retirement savings through the plan. Generally, your accumulated benefits will stay in the plan until you retire because a freeze can be reversed at any time. If you leave your job, your employer has the option of paying your benefits as a lump sum or monthly annuity.
Pension Plan Termination
In some cases, an employer may decide to terminate its pension plan altogether. This effectively means the plan will no longer exist. If your pension plan is terminated, you automatically become 100 percent vested in all of your accrued benefits. Your employer is required to give you the money as a lump-sum payment or transfer your benefits into an annuity. If the company doesn't have enough money to cover employee pension payouts, the Pension Benefit Guaranty Corporation will guarantee payments up to a certain limit.
If you decide to take a lump sum as a result of a pension freeze or termination, the money is taxable as income at your ordinary rate. You can defer any taxes due by asking the plan administrator to transfer the money directly to an IRA or another qualified retirement plan. You can also convert your pension lump sum into a tax-free qualified annuity. The money is only taxed once you start making withdrawals. Keep in mind that if you make a withdrawal before age 59 1/2, you may get hit with a 10 percent early withdrawal penalty.
Taking a lump-sum distribution from a frozen or terminated pension gives you more control over your retirement savings, but it also increases your level of risk because you're responsible for choosing your investments. If your plan doesn't allow for direct rollovers of lump-sum distributions, 20 percent of the money will automatically be withheld for federal taxes. Unless you make up the difference, you'll have to pay income tax on the part of your benefits that was withheld.
Rebecca Lake is a freelance writer and virtual assistant living in the southeast. She has been writing professionally since 2009 for various websites. Lake received her master's degree in criminal justice from Charleston Southern University.