How to Make Sense of Your Pension Options

How to Make Sense of Your Pension Options

February 23, 2023

Pension plans are still offered at many types of employers today. A pension plan is an employer-sponsored retirement savings plan the employer contributes toward to fund their employees' future retirement.

There are two types of pension plans:

  • Defined benefit plans that guarantee a monthly payment for life or a lump-sum amount when the employee retires.
  • Defined contribution plans the employer contributes to in the form of an investment account for the employee available to them when they retire.

According to the Bureau of Statistics, one-fourth of civilian workers had pension plans in 2021. Jobs that often have pension plans include healthcare, education, finance and insurance industries, military, utility companies, transportation industries, and others.

Some workers nearing retirement are facing a retirement date dilemma due to interest rate adjustments that will decrease their pension amount. For some, the pension calculation adjustment provides a reason to retire now rather than later since working longer will not recoup their lost pension dollars.

The two standard pension options offered at retirement are a fixed-amount monthly check for life or a pension payout. However, it is important to note that not all pension plans offer the choice of payout options. If you are unsure what your pension payout options or the amount may be, now is the time to contact your employer's human resources department to help avoid missing out on any of your hard-earned pay by working for your employer longer.

What to consider before exercising your pension payout

Once you decide to retire and before you exercise your pension payout options, there are many things to consider. A financial plan can help organize all of your information and answers to the following questions in one place to help you determine how long your pension may last. Here's what to consider:

  • Your current health status and life expectancy.
  • If you have life insurance for yourself and your partner.
  • If you have short-term and long-term debt, and if so, how much?
  • Other retirement income in addition to your pension.
  • How much income do you plan to replace with your pension and other investments?
  • What will your health care options look like after retiring?
  • If you have any dependents to support in retirement.
  • If there is an age difference between you and your partner.
  • Your Social Security retirement income calculation.
  • Your monthly budget.
  • If there are any lifestyle changes ahead that may impact how much monthly income you need.

Understanding your options for a pension payout 

Once you decide to retire, you have options of how you take your pension lump-sum payment. By working with financial and tax professionals, you must consider how each may impact your situation and taxes. Here are four options to consider when taking a lump sum pension payout:

  1. Cash out your pension- Cashing out your pension becomes a taxable event since the contributions were made with pre-tax dollars as a line item deduction for your employer. When you cash out your pension, regardless of age, you will pay taxes on it. Also, if you are younger than 59 1/2 when you cash it out, you will pay a 10% early-withdrawal penalty. The IRS allows penalty-free withdrawals from retirement savings vehicles, including pension plans, after age 59 1/2.

There are some exceptions to these IRS rules for pension plans. Therefore, you must consult your employer's HR department, tax professional, and financial professional before cashing out your pension.

Often, people decide not to cash out their pension and instead transfer their pension into a different retirement savings vehicle for the following reasons:

  • Delaying paying taxes- When you cash out your pension by taking a lump sum payment, taxes are due immediately. Transferring your pension to another retirement savings vehicle can delay paying taxes when transferring it to an IRA or Fixed-Indexed annuity. If taxes concern you, visit a financial and tax professional to determine which tax-advantaged strategies are appropriate for your situation.
  • Investment choices- Transferring your pension lump sum offers more investment choices that are not subject to the company's performance, interest rate adjustments, and payout adjustments.
  • Control- You and your financial professional can manage your investments in one place. Working with a financial professional can offer you the flexibility to change your retirement portfolio holdings as your situation or the market changes.
  • Accumulation- Transferring your lump sum into a retirement savings vehicle enables it to accumulate more value over time.
  1. Transfer your pension into an IRA- You can transfer your lump-sum pension amount into an existing IRA or open a new IRA and initiate the transfer through your former employer and financial professional. If you receive a pension payout check from your employer, don't cash it. You must deposit it into your IRA thirty days from the date of the check, or the IRS may consider it an early distribution subject to taxes and, if applicable, a 10% penalty if you're younger than 59 1/2.
  2. Transfer your pension into a fixed-indexed annuity- An annuity is a contract with an insurance company to provide an income stream during retirement for a specified period or the remainder of the annuitant's life. Annuities help address the risk of outliving retirement savings and can be purchased with monthly premiums or a lump-sum payment from a pension.

Fixed-indexed annuity returns are based on an index like the S&P 500. If the value of the index goes up, you receive a return based on that value. If the value of the index goes down, you receive a guaranteed minimum interest rate. Here are other things to know about indexed annuities:

  • Your principal is protected during a down market, and you won’t lose your initial investment or accumulation.
  • Accumulates on a tax-deferred basis.
  • The return is based on an index, which increases the annuity’s value over time.
  • Annuities provide a guaranteed lifetime income and protection against longevity risk since you receive payments for life.

It's important to note that fixed-indexed annuities may have risks, can be complex, costly, and aren’t always an appropriate retirement savings strategy for some people.

  1. Transfer your pension into a Roth IRA- If your employer's pension plan permits transfers into a Roth IRA, you can initiate the rollover into your Roth IRA or open a new one. Be aware that you will need to pay taxes on this type of transfer, so you must consult your tax professional before converting your pension to a Roth IRA. Also, taxes are due at the transfer time and cannot be deducted from the lump sum pension amount. It's important to note that earnings on the Roth IRA that accumulate after the transfer will be eligible for tax-free withdrawal when the Roth IRA has been open for at least five years and you are at least 59 1/2.

It's essential that you work with a financial professional to help you determine which pension option is appropriate for you. They can help you plan for your retirement and establish an actionable timeline as you work towards your financial and retirement goals.






Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal.  Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.

Fixed Indexed Annuities (FIA) are not suitable for all investors. FIAs permit investors to participate in only a stated percentage of an increase in an index (participation rate) and may impose a maximum annual account value percentage increase. FIAs typically do not allow for participation in dividends accumulated on the securities represented by the index. Annuities are long-term, tax-deferred investment vehicles designed for retirement purposes. Withdrawals prior to 59 ½ may result in an IRS penalty, and surrender charges may apply. Guarantees are based on the claims-paying ability of the issuing insurance company.

S&P 500 Index: The Standard & Poor's (S&P) 500 Index tracks the performance of 500 widely held, large-capitalization US stocks.

All indexes are unmanaged and cannot be invested into directly.

The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs. Their tax treatment may change.

All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.

This article was prepared by Fresh Finance.

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