Lump Sum vs. Life Annuity for a Pension Payout

It's never too early to begin developing your retirement savings strategy.
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Many employers offer some type of pension plan to help employees build their nest egg. These include defined benefit plans, which are funded by your employer, and defined contribution plans, which allow you to chip in money through payroll deductions. Once you retire, you'll have to choose between taking a lump sum payout or receiving monthly annuity payments.

Life Annuity

A life annuity pays you a specific amount of money each month for a set period of time. Federal law requires your employer to offer you a life annuity if you're enrolled in a defined benefit pension plan. Typically, it's up to the plan administrator to decide whether to give you the annuity option if you participate in a defined contribution plan. A single life annuity gives you the highest amount of money each month and pays you until you die. A joint and survivor annuity means a lower monthly payment, but your spouse will keep getting benefits even after your death.

Lump Sum Payout

Taking the lump sum means you effectively cash out your pension plan all at once. Generally, the amount of the lump sum is designed to equal what you would get if you took the annuity instead. Your company may also give you the option of combining a smaller lump sum with a life annuity. This gives you more flexibility because you can invest the lump sum portion and still have a steady stream of income from your monthly benefits.

Choosing a Payout Option

Your pension benefits may be fully or partially taxable, regardless of whether you take the lump sum or the annuity. If you take the lump sum, the money is treated like income and is subject to ordinary income tax. You can avoid the tax by doing a direct rollover into an IRA. Annuity payments from a defined benefit pension plan are fully taxable. If you're receiving benefits from a defined contribution plan, you don't have to pay taxes on the money you kicked in. You can calculate the tax-free part of your payment using the General Rule or the Simplified Method, depending on when your annuity payments began. If you take a lump sum or receive annuity payments before age 59 1/2, you'll have to pay a 10-percent early-withdrawal penalty.

Choosing a Payout Option

There are several factors to consider when you deciding whether you should take a lump sum or annuity payments. Some of the things you may want to evaluate include your life expectancy, overall health, expected future expenses and your overall retirement savings. You also need to think about how comfortable you are managing your own investments if you opt for the lump sum. Since you'll be responsible for making sure the money lasts, you'll need to make wise investment choices. If you're leaning towards the annuity, you also need to think about how well your payments will be able to keep up with inflation.

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