Should You Withdraw Your Pension as a Lump Sum?

Retirement Income Needs

An annuity provides a guaranteed monthly income through your retirement. A lump sum is a one-time payment based on your earnings and tenure at the company. The latter option gives you control of the money right away. You have the option to invest it how you see fit.

It's useful to have some form of guaranteed income in retirement to cover living expenses. When deciding whether to cash out your pension, compare the total monthly income that you will receive in retirement with your planned monthly expenses.

If your income just covers your expenses, you may want to stick to monthly pension payments. You will depend more on that income to stay afloat in retirement. However, if your guaranteed income far exceeds your expenses, it may make sense to withdraw your pension before retirement as a lump sum. In that case, you will depend less on a set monthly amount to meet your expenses.

Life Expectancy

Consider both your current age and your life expectancy when deciding whether to cash out your pension. In general, the older you are, the less time any money you invest has to grow, so the less upside there is in taking a lump sum. The younger you are, the more time the money you invest has to grow. That increases the benefit of taking a lump sum and investing it.

If you have a below-average life expectancy, the value of a lump sum increases, because you might not live to receive future payments but can receive a sum of money now. In contrast, if you have an above-average life expectancy, monthly payments may be better. They provide assurance that you will still receive monthly income well into the future. The lump sum may not stretch into later years of life. For a few reasons, it will be harder to make the money last through your retirement than if you were to maintain monthly payments:

It's up to You to Make the Money Last

It's easy to use up the lump sum if you don't set the right monthly budget. That can be hard to gauge, because there is no way of knowing for sure how long you will live. You may even be tempted to use the lump sum to pay for non-retirement spending. For example, you may use it for debts or other short-term expenses. The annuity option offers a steady income you can rely upon each month.

Market Downturns Can Reduce the Sum

Some people withdraw their pension as a lump sum before retirement because they believe that they can invest it in a way that yields greater returns. But a downturn in the market or poor investment choices can reduce the value of the amount you invest. This can result in a loss on the original lump sum that jeopardizes your retirement income. An annuity protects you against that outcome.

Rising Interest Rates Can Reduce the Value

The value of a lump sum may fall as interest rates rise, resulting in reduced buying power. You can store the money in an interest-bearing deposit account or invest it to combat inflation, but the interest rate might not keep pace with inflation. Investing can result in losses beyond the rate of inflation. In contrast, an annuity with a cost-of-living adjustment provides protection. That can preserve the buying power of your monthly payments over time.

Spousal Benefits

If you're married, you'll have to decide which pension distribution option is best for both you and your spouse. If you cash out your pension, the lump sum won't provide income for your spouse unless there is money remaining after your death.

If you fail to budget properly, or if you live longer than expected and exhaust the lump sum, your spouse may be financially insecure in retirement. Even if there is money left over for your spouse, they might not be as comfortable managing the money as you were.

When you withdraw your pension on a monthly basis, you'll be given several annuity options. Some of them will provide an income for your surviving spouse upon your death:

• Single-life annuity: This option usually results in the highest monthly pension payout. But the payments stop after your death, leaving your spouse with no income.
• Joint-and-survivor annuity: This plan provides a lower monthly income for you in retirement, but it provides income to your spouse once you die. Annuities often come in 50% or 100% options. With the 50% option, your spouse gets half of the monthly amount you received; with the 100% option, your spouse gets the full monthly amount you received.
• Single-life annuity with a certain term: You receive payments for a certain number of years. If you die before that period expires, your spouse is entitled to the remaining benefits.

For couples, spousal benefits can make joint-and-survivor and single-life term-certain annuities far more attractive than withdrawing a pension as a lump sum before retirement. If your spouse's Social Security survivor benefits won't be sufficient to meet their retirement income needs, then it's important to choose an annuity that grants them a pension income.

Tax Impacts

Taxes can eat into your pension payouts however you opt to take them. But, annuity payments are generally taxable at the time of withdrawal. That means you can defer tax payments until you retire. At that point, you would be taxed at a potentially lower ordinary income tax rate than you pay before retirement.

In contrast, you can only defer taxes on a lump sum if you do a direct rollover of the lump sum into an IRA account. Through this option, you would have a check sent to you but paid out to the intended rollover account.

If you don't do a direct rollover, you would have to pay current taxes on a lump-sum withdrawal at ordinary income tax rates. If your income tax bracket is higher now than it is in retirement, you could be losing a sizable chunk of the lump sum in taxes. To help cover the tax liability, a lump-sum payout from a pension that is not directly rolled over is subject to a 20% mandatory tax withholding. The employer will withhold 20% of your pension distribution before it is paid to you. If you overpay taxes or decide to roll the money over within 60 days, you will get back the excess taxes you paid as a tax refund.

Early Withdrawal Penalties or Reduced Payouts

You may be given the chance to cash out the vested amount of your pension as a lump sum in advance of when you plan to retire, but withdrawing your pension before retirement can be costly. If you are under 59 1/2 years of age when you receive the lump sum, a 10% early withdrawal penalty may be applied to you unless:

• You took the distributions in regular, equal payments after you were separated from employment.
• You have a permanent disability.
• The withdrawal was made after the death of the plan participant.
• You cash in a pension at age 55 or over because you were separated from employment.

Delaying the start of pension withdrawals makes sense even if you choose the annuity option. You might be able to retire at age 60, but that doesn't mean you have to start your pension at 60. Many pensions—although not all—offer much higher payouts if you begin benefits at a later age. You might be leaving money on the table if you haven't analyzed the payout options and you start your pension early.