By FPA member Eric S. Toya, CFP®
Last Updated: November 7, 2011
As you approach retirement, one important decision you may be faced with is whether to take your company sponsored retirement plan in a single lump sum distribution or as a traditional monthly pension. The lump sum may provide you with more money than you have ever had all at once. You may find that exciting, or quite possibly, frightening. On the other hand, you may be attracted to the security of a monthly pension. Before you make a decision, you should consider the pros and cons of both options.
Benefits of Lump Sum
- Investment Independence
- By taking a lump sum distribution, you have the independence to make your own investment decisions or hire a financial planner to guide you. If the funds are managed well, the ability to earn a higher return could afford you a higher standard of living throughout retirement or the ability to provide a larger inheritance to your loved ones.
- Leaving an inheritance
- While most pensions have options available to provide a continued income to your spouse upon your death, there is generally nothing left for your kids or other beneficiaries. In the event of an early death for you and your spouse, the remainder of the lump sum will go to your desired beneficiaries.
- Tax Flexibility
- If you opt for a monthly pension, your income will be taxed like ordinary income. Likewise any distributions from your lump sum [assuming you rolled it over into an Individual Retirement Account (IRA)] is also taxable. However, by making smart decisions around your IRA distributions, you can maximize your after tax withdrawals. For example, you may consider doing a partial Roth conversion to fill the bottom tax brackets in years which you have large tax deductions.
- Distribution Flexibility
You may decide to take a larger or smaller distribution in certain years depending on your situation. A larger distribution may be due to a large one-time expense (a major vacation, medical expense, home remodel). A smaller distribution may be due to reduced expenses, or cash flow from other sources (deferred compensation, receipt of inheritance).
Benefits of Monthly Pension
- No Investment Risk
- Poor or inappropriate investment decisions with the lump sum (for example, poorly timing the market or being overly conservative or aggressive), may result in low returns hampering your standard of living through retirement. The monthly pension eliminates that risk.
- Higher Guarantees
- Depending on the monthly payout options available, you may be able to secure a higher guaranteed income than you would from a lump sum. Keep in mind that we’re talking about the guaranteed amount, not total lifetime cash flow. Generally, the highest guaranteed income is one that pays you through your lifetime with nothing remaining for your spouse or other beneficiaries. Carefully consider your goals and family situation before selecting a pension option.
- Psychological Peace of Mind
- Not being able to see your lump sum amount rise and fall with the market may give you added peace of mind. It will also prevent emotional mistakes that are often made by investors, such as selling near the market bottom in a moment of panic.
Few decisions will have a greater impact on your quality of life through retirement. Be sure to evaluate the pros and cons of your options and consider hiring a financial planner to help you through the process.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC in Redondo Beach, Calif. Eric graduated from the University of Southern California with a BS in Finance and Accounting. Eric has been quoted in national publications, including The Wall Street Journal, Money Magazine and the Los Angeles Times.