Lump Sum or Annuity Distributions – What You Need to Know - Rodgers & Associates
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Lump Sum or Annuity Distributions – What You Need to Know

Federal Reserve Chairman Jerome Powell recently said they were not planning to raise interest rates anytime soon. The Federal Reserve believes it will take a couple of years for the economy to recover and expects to keep interest rates near zero until 2022¹. Chairman Powell is hoping the move to keep interest rates low will stimulate the economy and reduce unemployment. In the short term, interest rates will remain at historic lows.

Low interest rates are good news for borrowers, but not for those looking to retire and planning to supplement their income by investing in fixed income securities. Recent rates on the 10-year Treasury note were at 0.8%. That is not enough to even cover the rate of inflation over the past 10 years.

US Annual Inflation Rates
Source: USInfla​tion​Cal​cu​lator​.com

Low interest rates present an oppor­tunity for those looking to retire if they have the option of taking a lump-sum distri­b­ution from their pension. The amount of the lump sum is calcu­lated based on the present value of the monthly distri­b­ution they have earned during employment. The present value calcu­lation uses current interest rates. The Pension Protection Act of 2006 changed the rules for deter­mining this amount by allowing actuaries to use corporate bond rates rather than the lower Treasury bond rates. This was supposed to reduce costs for pension funds. Unfor­tu­nately, interest rates for corporate and treasuries have fallen, resulting in higher payouts for lump-sum distri­b­u­tions. A lower interest rate results in a higher lump-sum payout to the retiree.

Understanding the Types of Pension Distributions

There are two types of distri­b­ution options from a pension plan: annuity and lump sum. Not all employer plans offer a choice. All companies are required to offer an annuity payout in the form of monthly income. These payments will continue for the retiree’s life. When consid­ering early retirement, the annuity payouts are generally smaller because the worker has a longer life expectancy.

A lump-sum distri­b­ution is the payment, within a single tax year, of the present value of all lifetime payments. When choosing the lump-sum payment, the employee must elect whether to roll it over to an IRA or not. The employer is required to withhold 20% for taxes if the payment is made directly to the employee. Pension plans are qualified plans funded with pre-tax contri­bu­tions. All distri­b­u­tions will be subject to income tax and could be subject to a 10% early withdrawal penalty if the retiree is not 55 or older.

Directly rolling the lump sum over to an IRA avoids the 20% withholding and allows the money to continue to grow tax-deferred until withdrawn. A retiree could roll over the lump sum to an IRA and then start taking monthly distri­b­u­tions immedi­ately. The payments could be stopped or modified at any time. Stopping monthly annuity payments is generally not an option after a retiree elects lifetime payments. An IRA rollover also allows the owner to take out a lump sum amount at any time. Those withdrawals would be subject to income tax.

Another advantage of the IRA is the ability to name a benefi­ciary who will receive the balance in the account when the owner dies. Annuity payments usually allow only a spouse to be named as joint benefi­ciary and the payments stop after the joint owners are deceased. IRAs allow multiple benefi­ciaries to be named. Electing the annuity payment is an irrev­o­cable decision. When rolling over a lump sum into an IRA, the owner could always decide later to set up a guaranteed monthly income by investing the lump sum into an immediate annuity.

The final consid­er­ation should be the amount of your monthly pension payments and whether they are covered by the Pension Benefit Guaranty Corp (PBGC). The PBGC insures payments in 2020 up to a maximum of $5,812 per month on a 65-year old single-life pension. Any payment over this amount could be lost if the pension plan goes bankrupt and the PBGC has to step in. A retiree in this situation should take the lump-sum rollover and could purchase immediate annuities if they still want the guaranteed lifetime income.

Rick’s Insights

· Low interest rates offer an excellent oppor­tunity for anyone that can take a lump-sum distri­b­ution from their pension.

· All pension plans must offer lifetime annuity payments.

· Lump-sum distri­b­u­tions have some advan­tages over annuity payments including the ability to convert to lifetime payments at a later date.


¹Federal Reserve Will Keep Interest Rates Near Zero Until 2022. By Sergei Klebnikov, Forbes magazine.