While many companies sponsor 401(k)s or similar retirement plans, there are still some employers that offer traditional pensions. Pension funds are structured to provide employees with a steady stream of retirement income. The expense of maintaining these plans has prompted some companies to offer workers a voluntary retirement package that includes a lump sum distribution of benefits. If you're considering taking a lump sum offer, it pays to know what the pros and cons are.
How Lump Sums Work
A pension is a type of defined0benefit plan, which means you're guaranteed a specific amount of money when you retire. Typically, benefits are paid out monthly as a lifetime annuity. When you take a lump sum instead, you agree to receive all your benefits at once. The amount of money you receive is supposed to equal what you would get if you opted for the lifetime monthly payments. Each employer uses a different formula to determine how much money you're entitled to, but generally, your benefits are based on your age, years of service and salary at retirement.
If you take a lump sum distribution, you'll have to pay taxes on the money you receive. When you take the money out, 20 percent will automatically be withheld for federal taxes, and you'll have to report the rest of the distribution as ordinary income. If you're under age 59 1/2, you may also have to fork over an additional 10 percent early withdrawal penalty. You can defer taxes by rolling your pension lump sum into another qualified retirement account, such as an IRA. If you ask your plan administrator to roll the money over directly the 20 percent withholding doesn't apply.
Lump Sum Benefits
Taking a lump sum distribution offers several advantages. First, it allows you to be as risky or conservative as you like when it comes to investing the money. If you're knowledgeable about investing, taking the lump could yield a bigger return than you would get with a monthly annuity. A lump sum distribution also makes it easier for your money to keep up with inflation. Typically, annuity payments are structured to be level over the course of your lifetime. Investing part or all of your lump sum in assets that are designed to keep up with inflation can give you more bang for your buck overall.
Taking a lump sum could quickly deplete your retirement savings if you're not careful about how the money is spent. You need to make sure that the lump sum is enough to sustain your cost of living in the long term, especially if you don't have additional sources of retirement income. You also need to consider the range of investments available if you're planning to roll your pension money into another retirement account or purchase a retirement annuity. If your investments don't perform well, taking the lump sum could end up costing you money in the long run.
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