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?
Taking a lump-sum payment can be very risky. Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. In contrast, 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
A monthly pension payment gives you a fixed amount every month over your whole life, so you don't have to worry about changes in the stock market. In contrast, a lump-sum payout can give you the flexibility of choosing where to invest or save your money, and when and how much to withdraw.
Is it better to take a pension or lump sum? ›
Taking a lump-sum payment can be very risky. Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. In contrast, 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.
What is the 6 rule for pension lump sum? ›
Under the rule, if the monthly pension offer is 6% or more than the lump sum, it makes more sense for your clients to go with the guaranteed monthly income. But if the value is less than 6%, your clients would benefit more by getting the lump sum and making smart investments.
How do they calculate pension lump sum payout? ›
The amount of the lump sum is based on a formula that your pension provider determines using factors including IRS-mandated interest rates, your age, and mortality tables. 2 The lump-sum offer is supposed to equate to taking your monthly pension payments as one large sum.
Is it better to take payments or a lump sum? ›
A lump sum is good for funding long-term investments, while an annuity guarantees larger total payouts. Choose based on your financial goals and applicable rules surrounding the specific lottery. An annuity ensures a larger total payout over years.
Do you pay taxes on a lump sum pension payout? ›
Mandatory income tax withholding of 20% applies to most taxable distributions paid directly to you in a lump sum from employer retirement plans even if you plan to roll over the taxable amount within 60 days.
Why do people take a lump sum from a pension? ›
You want to manage your tax bill
Taking your pension pot as a number of lump sums can help here because it allows you to take your tax-free cash in stages. If you're a basic-rate taxpayer, you could withdraw an amount each year that keeps you under the higher tax rate threshold.
What is the difference between a lump sum and a pension payment? ›
A Lump Sum withdrawal is simply an amount accessed from your SMSF that is not a Pension payment. You can make Lump Sum withdrawals whenever you like from your SMSF once you turn 65 or are aged between preservation age and 64 and "Retired", regardless of whether you have commenced a Pension.
What is a typical pension payout? ›
A typical multiplier is 2%. So, if you work 30 years, and your final average salary is $75,000, then your pension would be 30 x 2% x $75,000 = $45,000 a year. That $45,000 becomes your guaranteed lifetime income.
How can I avoid taxes on a lump sum payment? ›
One powerful way to reduce the taxes on your settlement is to use a structured settlement annuity. Here's how a structured settlement annuity works: Instead of receiving the entire settlement amount in one lump sum payment, a portion of the settlement funds can be allocated to purchase a structured settlement annuity.
Joint and survivor options are often best for those who are married, older than their spouse, or in poorer health than their spouse. To help mitigate premature death risks while still receiving a higher payment than joint and survivor amounts, you can also choose a single-life annuity (either term or period certain).
What is the formula for lump sum amount? ›
The formula for a lumpsum calculator is A = P*(1 + r) ^ t, essential for projecting the future value of a lumpsum investment over time. Where A represents the future value, P denotes the principal investment amount, r signifies the expected rate of return, and t indicates the duration of the investment.
How much does a $300,000 annuity pay per month? ›
With a $300,000 fixed immediate annuity, a 65-year-old man could receive around $1,450 to $1,950 per month for life, while a 65-year-old woman may get $1,800 to $2,200 per month. These payments are guaranteed for as long as the annuitant lives.
Why is the lump sum payout so much less? ›
You'll also see more taxes are withheld if you select the lump sum cash payout. Every state is required to withhold 25% in a federal lottery tax, and after additional withholdings, you'll be losing roughly 37% of your jackpot to taxes.
What is the smartest thing to do with a lump sum of money? ›
Pay down debt:
One of the best long-term investments you can make is to pay off high-interest debt now. This is especially true of credit card debt, which is likely costing you between 10% and 15% a year, which is much more than you can reliably make by investing your money.
Which is better lump sum or monthly payments? ›
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.
Should you consider a lump sum pension withdrawal? ›
It is practical to consider allocating amounts over the minimum pension requirement as a lump sum withdrawal to maximise the tax-free environment of the fund. NOTE: it is not a requirement to take the minimum before taking a lump sum, as long as the minimum is taken over the course of the year.
