What is a lump sum offer?
Companies and municipalities are in need of reducing or eliminating their pension liability. They can do so by having a third-party company provide retirees with the option of an annuity or a lump sum equivalent to their pension.
How is the lump sum computed?
The lump sum payment is derived using a blended IRS sanction rate that is based on corporate bonds and an IRS unisex mortality table. In theory, the lump sum payment will be equal to the sum of pension payments one would receive for the remainder of their life.
Should I take the lump sum?
The lump sum generally makes sense to retirees with a short life expectancy (e.g. poor health), retirees with a desire for flexibility in their withdrawals, retirees with non-spouse beneficiaries, and those who are willing to invest the lump sum and assume investment risk.
When should I be considering the annuity?
The annuity makes sense when the retiree has a relatively long life expectancy (e.g. good genetics, good health), is in need of income security, is very conservative in their investing and has other assets to hedge against inflation.
Why does age matter?
The lump sum has one definite feature of flexibility. Once you take it, you have quite a bit of leeway in the frequency and timing of withdrawals. For most retirees, the logical tax move is to roll the lump sum into an IRA. This leaves three age points to consider:
- If you’re under 59 ½ and roll the lump sum into an IRA, you can only get money out of the IRA penalty-free by using a section 72(t) withdrawal. The 72(t) withdrawal has a low interest rate and some conservative restrictions.
- For retirees between 59 1/2 and 70 1/2, the retiree has total flexibility, and would only pay tax on the withdrawals.
- At 70 1/2, the IRA owner must begin required minimum distributions (RMD) or face a prospective 50% penalty.
Do I have to roll my lump sum into an IRA?
No. You can take the lump sum and include it in your taxable income (which might push you into a higher bracket). You can also roll it into another qualified plan, like a 401(k) or pension plan (if the plan allows a roll-in). Or, if you were born before 1/02/36, you can take advantage of a special treatment called ’10-year forward averaging’.
Why does it matter if I’m a male or female?
Federal law requires gender not be a factor in the calculation of your lump sum. In reality, women will generally live longer than men and this fact should be considered when making a decision.
Can I roll the lump sum to a Roth IRA?
In short, yes. In practice, look at it carefully, especially the amount. Roth IRAs have some attractive advantages: they are tax-free on qualifying distinctions, they are not subject to the RMD rules at age 70½, and an heir can receive a Roth tax-free. However, to get any part of the lump sum (or any taxable IRA, for that matter) to a Roth, you must pay the tax on the amount transferred. For that reason, we typically advise a partial or ‘serial’ conversion where you stay in the same tax bracket and convert a portion of the lump sum. You can do multiple conversions over multiple years and manage your tax brackets.
Is the annuity option still insured by the Pension Benefit Guaranty Corporation (PBGC)?
PBGC insurance will vary depending on the company or municipality offering the buyout. Check with your HR department or your lump sum offer documentation.
How am I protected from inflation?
In the annuity, you aren’t. In the lump sum, you have the opportunity to invest the money and create some sort of inflation protection, whether it is Treasury Inflation Protected Securities (TIPS), equities or hard assets.
What happens to the money when I die?
With the annuity, if you take the same payment as the plan and are unmarried, the annuity payment probably ends. If you are a married and have elected the joint and survivor (which was the normal form of payment for married retirees) your spouse will receive 65% of the reduced benefit. When your spouse dies, the annuity ends. If you take the lump sum, any undistributed balance goes to your designated beneficiaries. In this case, if your spouse is your beneficiary, and you have rolled the lump sum to an IRA, then your spouse may roll your IRA into their IRA. If you leave your IRA to non-spouse beneficiaries (e.g. children), they must accommodate the distribution rules, but may take it over their life expectancy.
What happen if interest rates rise?
If you are in the annuity, nothing happens. You receive the same amount. If you take the lump sum and have investment flexibility, you can invest at higher rates.
What is the tax flexibility you discuss in the White Paper?
It should be no surprise that taxes are complex. Tax flexibility refers to the ability of an owner of an IRA to manipulate their income, and subsequently, their taxes. There are many deductions and credits, ranging from medical to college tuition, to social security taxation to Medicare B and D premiums that are based on adjusted gross income (AGI). Having the ability to manipulate income provides the opportunity to manipulate tax benefits.
How does the lump sum affect my estate?
Any residual balance in your IRA rollover will go to the designated beneficiaries and the value is included in the taxable estate. The annuity ends upon death and has estate-planning ramifications to the named beneficiary. We sometimes advise clients to look at an ‘IRA trust’ to assure the non-spouse beneficiary has all tax advantages and doesn’t squander the IRA. In addition, inherited IRAs of a non-spouse beneficiary are subject to the claims of the beneficiary’s creditors. An IRA trust can protect against this.
Any other things I should think about?
The lump sum is a personal decision. Do your analysis, research, and get multiple opinions. We are happy to provide a second look at your decision.