Lump-Sum vs. Pension Payments: An Overview
Those approaching retirement and eligible for a pension often weigh accepting the traditional, lifetime monthly payments or taking a lump-sum distribution.
Monthly pension payments are a fixed dollar amount, begin at retirement, and last until a retiree's death. Some plans offer a survivor's benefit for a living spouse. A lump sum distribution is a one-time cash disbursem*nt at retirement. The retiree is solely responsible for managing the funds throughout retirement.
Key Takeaways
- Pension payments are made for the rest of a retiree's life.
- Lump-sum distributions allow individuals to spend or invest the money.
- People who take a lump sum may outlive their money, while traditional pension payments continue until death.
Lump-Sum Distribution
A lump-sum distribution is a one-time payment from a pension administrator. Individuals have access to a large sum of money they can spend or invest. A pension payment annuity is commonly a fixed payment, but a lump sum offers flexibility and, if invested properly, may also provide regular income. Those who take a lump-sum distribution can name a beneficiary to receive any money left after death.
Income from pensions is taxable. However, individuals can roll over a lump sum into an IRA and control when to withdraw the funds and pay income tax.Retirees will eventually have to take required minimum distributions (RMDs) from their IRA, but that won’t happen until age 72 or 73.
Rolling a lump sum pension payment into an IRA lets individuals plan when they take their distributions—and when they'll pay the associated taxes.
Pension Payments
A pension payment is a set monthly payment payable to a retiree for life and, in some cases, for the life of a surviving spouse. Some pensions include cost-of-living adjustments (COLA), meaning payments are indexed to inflation. A regular pension check can help retirees budget and control overspending. Retirees with company health insurance may need to opt for pension payments because coverage may stop if an employee takes a lump sum.
According to research from the Consumer Financial Protection Bureau, retirees in 2020 with pension income were more likely to remain financially stable than those who had cashed out the lump sum. Of those with regular payments, 73% could maintain the same spending level after five years, compared to only 56% of those who had chosen the lump sum.
One threat to pensions is that an employer fails to pay long-term. However, pension benefits are safeguarded by the Pension Benefit Guaranty Corporation (PBGC), a government entity that collects insurance premiums from employers sponsoring insuredpension plans. The PBGC only covers defined-benefit plans, not defined-contribution plans like 401(k)s. In 2024, the maximum annual benefit is $85,295.40 for a straight-life annuity for a 65-year-old retiree.
If a pension administrator goes bankrupt, pension payments could stop, though Pension Benefit Guaranty Corporation (PBGC), a federal agency, insurance covers most people.
Key Differences
Lump Sum
All pension money is distributed at once at retirement
The retiree must manage the funds throughout retirement
Lump sum money can be rolled over into an IRA
Retirees can designate beneficiaries of the funds
Pension Payments
Payments are made monthly to the retiree until death
The PBGC provides insurance in case the pension administrator is unable to pay
Monthly payments may cease once the retiree dies unless there are survivor's benefits
Companies may require retirees to take monthly payments to keep health insurance benefits
How Do Companies Calculate Pension Payments and Lump Sum Distributions?
From an actuarial standpoint, the typical recipient receives approximately the same amount of money whether choosing the pension or the lump sum. The pension administrator calculates the commuted value using the average lifespan of retirees and adjusts the payment schedule accordingly. Retirees with a longer-than-average lifespan will probably receive more money taking lifetime payments.
What Are the Disadvantages of Taking a Lump Sum?
Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. A monthly payment offers a steady income for the remainder of one's life, and in some cases can also be passed on to a spouse. Retirees who choose a lump sum could put part of a lump sum into a fixed annuity with the help of a financial advisor.
Is a Pension Plan the Same As a Defined Benefit Plan?
Yes, a private pension plan is a defined benefit plan where the employer makes most contributions on behalf of the employee for their retirement.
The Bottom Line
For some, a lump-sum pension payment makes sense. For others, having less upfront capital is better. In either case, pension payments should align with a retiree's personal goals. A financial advisor can guide those considering whether to choose a monthly payment or invest a lump sum for the long term.
FAQs
Pension payments are made for the rest of a retiree's life. Lump-sum distributions allow individuals to spend or invest the money. People who take a lump sum may outlive their money, while traditional pension payments continue until death.
Is it better to take lump sum or monthly payments for pension? ›
Monthly payments over time are the format that most people associate with pensions. However, a lump sum payment can, sometimes, be the better option. Depending on what your company offers and what kind of returns you can pursue, you might collect more from your money in the long run by taking it all up front.
Why a pension lump sum option is better than an annuity payment? ›
If the market struggles, your annuity payments will remain the same and your company will likely to be required to make greater contributions to the pension plan to compensate for lower than expected investment returns. If you take a lump sum, no one is responsible for taking care of your money other than you.
Do you have to pay taxes on a lump sum pension payout? ›
The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means they're taxed at the highest income tax rates. The agency says that mandatory income tax withholding of 20% applies to the majority of lump sum distributions from employer retirement plans.
Is a pension lump sum? ›
You have a number of options for how to access the money in your pension pot. Your options for taking your personal pension are: take some or all of your pension pot as a cash lump sum, no matter what size it is. buy an annuity - you can take a cash lump sum too.
What is the 6 rule for pension lump sum? ›
As a general guide, you can use the 6% Rule when evaluating the two options. It's a straightforward tool to help assess which choice makes more financial sense over time. Here's how the 6% Rule works: If your monthly pension offer is 6% or more of the lump sum, it might make sense to go with the guaranteed pension.
What is the best pension option to take? ›
Single-life annuities
This is often an excellent option if you're single with no dependents. If you're married, however, keep in mind this option is limited as it lacks payouts for your surviving spouse; you'll therefore need to evaluate other sources of retirement income to determine if he or she will need the money.
What are the disadvantages of taking a lump sum pension? ›
What Are the Disadvantages of Taking a Lump Sum? Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. A monthly payment offers a steady income for the remainder of one's life, and in some cases can also be passed on to a spouse.
Is it better to take the lump sum or payments? ›
The lump sum provides a significant amount of immediate cash. Many opt for this option to avoid long-term tax implications. Annuity payments offer tax benefits and can prevent overspending lottery winnings. They provide guaranteed income, and can lead to more money in the long run.
Does a lump sum pension affect social security? ›
If two-thirds of your government pension is more than your Social Security benefit, your benefit could be reduced to zero. If you take your government pension annuity in a lump sum, Social Security will calculate the reduction as if you chose to get monthly benefit payments from your government work.
You can retire with Social Security and a pension at the same time, but the Social Security Administration (SSA) might reduce your Social Security benefit if your pension is from a job at which you did not pay Social Security taxes on your wages. There are two different kinds of pensions: covered and noncovered.
How much federal tax do I pay on my pension? ›
Lump-Sum Benefits
A mandatory 20% federal tax withholding rate is applied to certain lump-sum paid benefits, such as the Basic Death Benefit, Retired Death Benefit, Option 1 balance, and Temporary Annuity balance.
How much is the average pension in the US? ›
What is the average retirement income by state?
| State | Average retirement income |
|---|
| Alaska | $36,023 |
| Arizona | $28,725 |
| Arkansas | $21,967 |
| California | $34,737 |
47 more rowsFeb 28, 2024
If you expect to have an above-average life span, you may want the predictability of regular payments. Having a payment stream that will last throughout your lifetime can be comforting. However, if you expect to have a shorter-than-average life span because of personal reasons, the lump sum could be more beneficial.
How do they calculate pension lump sum payout? ›
However, most will use the average of your three highest years of compensation as a start for your payout calculations. Once this number is clear, it's multiplied by the percentage factor for your plan. You then multiply the subsequent number by the amount of years you were employed at the company.
Can I transfer my pension to my bank account? ›
For most pension schemes, it is not possible to access your pension until you are at least 55. You can, however, transfer to a new provider at any time. But if you're 55 or older, you can move your pension into your bank account. Even then, though, it is unlikely to be a good idea to take all of your pension in one go.
Is it better to put lump sum or monthly? ›
In a given year, for instance, it is much closer to 50/50 whether a lump sum at the start works out better than splitting it up over the twelve months, and you stand to be better off with monthly investments if the market falls in the shorter term.
Is it better to pay extra monthly or lump sum? ›
Since your interest is calculated on your remaining loan balance, making additional principal payments every month will significantly reduce your interest payments over the life of the loan. By paying more principal each month, you incrementally lower the principal balance and interest charged on it.
Should I do a payment plan or lump sum? ›
Lump-sum payments are ideal for those who can afford them, offering a quick resolution and potential savings. However, installment payments are a more practical solution for individuals who need to manage their cash flow and cannot afford to pay off their debt in one go.
Is it better to invest in lump sum or monthly payments? ›
The main difference between a lump-sum and a monthly payment is that with a lump-sum option, you get to have control over how your money is invested and what happens to it once you're gone. If that's the case, then the lump-sum option is your best bet.
