How to Make the Most of Your Pension
May 3, 2021
If you have worked for a large company, labor union, or government agency, you likely have a pension. When it comes time for you to retire, you will generally have two pension options to choose between. Your pension can either take the form of an annuity or a lump sum. Annuities pay a set amount of money per month, often for the rest of your life. On the other hand, a lump sum is a one-time payment based on how much an annuity would have paid over your lifetime. Both options have their pros and cons, but in this article, we will focus on why you should choose a lump sum pension.
Why Choose a Lump Sum Pension?
Taking your pension as a lump sum can provide you with much more flexibility in retirement than an annuity. There are three primary benefits to choosing the lump sum option.
- Inflation Hedge – Receiving a monthly annuity payment for the rest of your life sounds good, but the drawback is the payment never changes. Very few pensions offer annuity payments with cost-of-living increases. The annuity payment you receive at the beginning of your retirement will buy much less as you get older. With just 3% inflation, prices double in less than 25 years. This means your annuity payment could buy 50% less toward the end of your retirement.
- Unexpected Costs – Life is full of surprises and unexpected things happen. As we get older, health care costs can arise that are not covered by insurance. A loved one may need assistance with some of their daily activities. These unexpected expenses can cause financial hardship if your annuity payment isn’t able to pay for them. Taking the lump sum and investing it can provide you with financial resources to cover unexpected expenses. It can also prevent you from needing to take out loans or sell assets to pay for these expenses.
- Legacy Planning – Pensions are required by law to offer survivor benefits to a spouse or life partner. These benefits reduce your monthly payment because the annuity will have to last for two lifetimes. Upon the second death, the annuity payment stops. If you and your spouse die prematurely, you don’t receive the full pension benefit, and there is nothing left for other beneficiaries. However, if you take the lump sum and invest it, you can pass on the remainder to your heirs and provide a legacy to your family.
Investing Your Lump Sum
When you take your pension as a lump sum, you are responsible for investing it to make sure the money can last your lifetime. Keep in mind there is always risk with investing, but it is important to invest your lump sum pension for growth. You will want to determine the appropriate asset allocation to manage investment risk. Asset allocation is the process of diversifying your investments across a variety of asset classes. This strategy involves accepting a certain amount of investment risk and blending different asset classes together to have the best return potential for the chosen level of risk. If you are a very conservative investor and uncomfortable with market risk, you may want to take your pension as an annuity instead of a lump sum.
Rolling a Lump Sum Over to an IRA
There are two basic ways to receive your lump sum pension, as a taxable cash payment or as a tax-free rollover into a retirement account. If you take the lump sum as a cash payment, you will owe income taxes on the total amount. Typically, this is not a good idea because your lump sum may be hundreds of thousands of dollars, and taking a cash payment would cause you to pay significant taxes.
Having your lump sum rolled directly into a traditional IRA is a better choice. This allows you to defer income taxes on your pension until you take money from your IRA. Rather than paying taxes on the entire lump sum upfront, you will only have to pay taxes on the amounts you take as distributions from the IRA. When you reach age 72, you will have to begin taking required minimum distributions (RMDs) from your IRA. You can use the distributions for whatever you want, paying for living expenses, vacations, gifting money to family members, or making charitable donations. This gives you plenty of choices about how to use your pension in retirement.
Selecting the lump sum option for your pension can provide much more flexibility with your finances compared to the annuity option. It can help pay for unexpected costs in retirement, increase your purchasing power over time, and provide an inheritance for your family or charities. The right financial advisor can manage the investment risk of your pension and help you make informed financial decisions so you can enjoy a comfortable retirement.
Trinity Wealth Management
If you’re currently faced with the decision between various pension options and would like to know more about the pros and cons of each, we can help. Contact us today to schedule a consultation with our fiduciary financial advisors, including retirement planning specialists.
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