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

Lump Sum or Annuity – What You Need to Know

Federal Reserve Chairman Ben Bernanke recently announced the third round of quanti­tative easing hoping to boost economic growth and reduce unemployment. The Federal Reserve will expand its holdings of long-term securities by purchasing $40 billion of mortgage debt a month. Critics say the move is the equiv­alent of printing more money. Chairman Bernanke is hoping the move will keep interest rates low in order to stimulate the economy and reduce unemployment. The short-term impact will certainly be to keep interest rates at historic lows.

Low interest rates are good news for borrowers but not 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 1.8%. That is not enough to even cover the rate of inflation over the past 10 years.

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Inflation Rates Graph of 2002-2012

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 since than resulting in higher payouts for lump sum distri­b­u­tions. A lower interest rate results in a higher lump sum payout to the retiree.

There are two types of distri­b­ution options from a pension plan– annuity and lump sum. Hopefully your employer will offer you the choice. All companies are required to offer you an annuity payout in the form of monthly income. These payments will continue for the rest of your life. When consid­ering early retirement, the annuity payouts will be smaller because you have 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 direct to the employee. Pension plans are qualified plans funded with pretax contri­bu­tions. All distri­b­u­tions will be subject to income tax and could be subject to a 10% early withdrawal penalty if the retiree is not age 55 or older.

Rolling the lump sum over directly 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 anytime which is not an option available to a retiree who elects the annuity payment. An IRA rollover would also allow 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 you die. Annuity payments usually allow only a spouse to be named as joint benefi­ciary and the payments stop after the joint owners are gone. 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 it is covered by the Pension Benefit Guaranty Corp (PBGC). The PBGC covers payments in 2012 up to the maximum of $4,653 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 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 many advan­tages over annuity payments including the ability to convert to lifetime payments at a later date.