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Some weeks ago, one winning Mega Millions lottery ticket was sold at a ShopRite in Neptune, NJ for an astounding $1.13 billion. Like most who dreamt about winning such a windfall, the question we ask ourselves is do I take a lump sum, or do I take an annuity payment? That is a fun exercise.
Now let us look at reality when the choice of a lump sum distribution vs. an annuity has to do with retirement. People with retirement pension plans must make that life changing financial decision. Both personal and financial factors should be considered when facing that decision.
To make this decision you need to consider the longevity risk. From an actuarial standpoint, the lump sum payout is equivalent to the monthly payouts, based on the average lifespans of retirees. A pension plan continues payouts until death, and it can also provide for survivor benefits (typically a spouse).
Those who live a very long life end up on the better side of that actuarial curve with the monthly payouts. If you are single and have medical issues you may get more from the lump sum.
Even with a long life, it may be possible that properly invested, the lump sum would earn more money overall. Not all pension plans are indexed for inflation either, making inflation risk a serious concern when it comes to running out of money with monthly payments. Social security is adjusted for inflation each year, but the rest of a retirement portfolio needs to take inflation into account.
We know that there can be large expenses during retirement, especially when it comes to health. The debt from these expenses could eat away at retirement resources, but with a lump sum one might be able to cover those expenses right away. On the other hand, having access to all the money at once might encourage overspending in the beginning. Data from a Consumer Financial Protection Bureau (CFPB) May 2020 publication titled "Retirement Security and Financial Decision-Making: Research Brief" provides a cautionary tale as they find that:
"Among retirees with a pension, the analysis shows that those who chose a pension cash-out were less able to maintain the same spending level for five years after retiring than those who chose to receive their pension as a monthly payment (73 percent versus 56 percent)."
Are there tax implications to taking the lump sum payment? Yes. First and foremost, the money should be rolled into an IRA to maintain its tax-advantaged status. Otherwise, it could all become taxable, all in the same year bringing you into a higher tax bracket. When possible, the best way to do this is with a direct rollover from the plan provider to the new IRA plan provider. The sixty-day rule comes into play with rollovers, so realize that you do not have until the end of the tax year to move the money. Once the money is rolled over to an IRA plan you are subject to the required minimum rules. The IRS requires you to begin taking distributions from your IRA in the year you turn 73.
Should the money not be rolled over, there could also be a 10% penalty for an early withdrawal before age 591/2, and once it is moved over, it will fall under the same required minimum distribution rules as other IRAs.
Overall, when it comes to taking the lump sum payment it is not just a question of how many dollars will be received. It is also a question of addressing the enjoyment within retirement. Are you going to be more comfortable knowing that pension check is coming every month? Even if the business goes bankrupt, the pension benefits are safeguarded by the Pension Benefit Guaranty Corporation up to an annual maximum. Does the pension have cost of living adjustments, or will you need to reduce spending to offset inflation?
Managing the investment side of retirement money can be difficult for the average retiree. At Garden State Trust Company, we hope to make it a little easier by providing a consultation where we look at all the different assets you may have that would affect your retirement picture. We then ask questions to help you create a financial roadmap for your retirement and make sure to share our experiences helping retirees.
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