Should You Withdraw Your Pension as a Lump Sum?

Here's what to consider before you cash out your pension

To save money on future pension payouts, a company may give employees who participate in a pension plan the opportunity to withdraw their pension as a lump sum when they leave the company or long after. The lump-sum option may be offered to former employees or current retirees who are partially or fully vested in the pension plan—that is, their tenure at the firm allows them to keep some or all of the assets in the plan. In exchange, these individuals give up their right to receive future monthly annuity payments. Before you jump at the option to cash out your pension, do a thoughtful analysis that considers these issues.

Retirement Income Needs

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An annuity generally provides a guaranteed monthly income throughout your retirement, whereas a lump sum is a one-time payment based on your earnings and tenure at the company. The latter option gives you immediate control of the money and the option to invest it how you see fit.

It's useful to have some form of guaranteed income in retirement to cover living expenses (medical expenses and utilities, for example). When deciding whether to cash out your pension, compare the total guaranteed monthly income (pension and Social Security income, for example) you will receive in retirement with your planned monthly expenses.

If your income just covers your expenses, you may want to stick to monthly pension payments because you will be more dependent on that income to stay financially afloat in retirement. If, however, your guaranteed income far exceeds your expenses, it may make sense to withdraw your pension before retirement as a lump sum because you will be less dependent on a set monthly amount to meet your expenses.

Life Expectancy

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Consider both your current age and your life expectancy when deciding whether to cash out your pension. In general, the older you are, the less time any money you invest has to grow, and the less upside there is in taking a lump sum. The younger you are, the more time the money you invest has to grow, which increases the benefit of taking a lump sum and investing it.

If you have a below-average life expectancy, the value of a lump sum increases because you may not live to receive future payments but can receive a whole pot of money now. In contrast, if you have an above-average life expectancy, monthly payments are preferable because they provide assurance that you will still receive monthly income well into the future. The lump sum may not stretch into later years of life. In addition, it will be more difficult to make the money last throughout your retirement than if you were to maintain monthly payments, for a few reasons:

It's up to you to make the money last. It's easy to prematurely use up the lump sum if you don't allocate the right monthly budget for the lump sum, which is difficult to gauge given the uncertainty involved in predicting your life expectancy. You may even be tempted to use the lump sum to pay for non-retirement spending—for example, debts or other short-term expenses. The annuity option offers a steady income you can rely upon each month.

Market fluctuations can diminish the original sum. Some people withdraw their pension as a lump sum before retirement because they believe that they can invest it in a way that yields greater returns than keeping it in the pension. But a downturn in the market or poor investment choices can reduce the value of the amount you invest and any income you generate from it, potentially resulting in a loss on the original lump sum that jeopardizes your retirement income. An annuity protects you against this outcome.

Rising interest rates can reduce the value of the lump sum. The value of a lump sum may fall as interest rates rise. This results in reduced purchasing power of the original lump sum. You can store the lump sum in an interest-bearing deposit account or invest it to combat inflation, but the interest rate may not keep pace with inflation, and investing can result in losses beyond the rate of inflation. In contrast, an annuity with a cost-of-living adjustment provides inflation protection to preserve the purchasing power of your monthly payments over time.

Spousal Benefits

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If you're married, you'll have to decide what pension distribution option is best for both you and your spouse. If you cash out your pension, the lump sum won't provide income for your spouse in retirement unless there is money left over after your death or you allocate a specific portion of the distribution for your spouse and budget accordingly.

If you fail to budget properly, or you live longer than expected and exhaust the lump sum, your spouse may be financially insecure in retirement. Even if there is money left over for your spouse, she may not be as comfortable managing the money or potential investments as you were.

When you withdraw your pension on a monthly basis, you'll be given several annuity options, some of which will provide an income for your surviving spouse upon your death:

  • Single-life annuity: This option usually results in the highest monthly pension payout. But the payments stop after your death, leaving your spouse with no income.
  • Joint-and-survivor annuity: This plan provides a lower monthly income for you in retirement, but it provides income to your spouse once you die. Annuities often come in 50% or 100% options. With the 50% option, your spouse gets half of the monthly amount you received; with the 100% option, your spouse gets the full monthly amount you received.
  • Single-life annuity with a certain term: You receive payments for a certain number of years. If you die before that period expires, your spouse is entitled to the remaining benefits.

For couples, the potential for spousal benefits can make joint-and-survivor and single-life term-certain annuities far more attractive than withdrawing a pension as a lump sum before retirement. If your spouse's Social Security survivor benefits won't be sufficient to meet his retirement income needs, then it's all the more important to choose an annuity that grants him a pension income.

Tax Impacts

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Taxes can eat into your pension payouts whether you receive them in installments or as a lump sum. However, annuity payments are generally taxable at the time of withdrawal. This means you can defer tax payments until you retire, at which point you would be taxed at a potentially lower ordinary income tax rate than you pay before retirement.

In contrast, you can only defer taxes on a lump sum if you do a direct rollover of the lump sum into an IRA account. Through this option, you would have a check sent to you but paid out to the intended rollover account.

If you don't do a direct rollover, you would have to pay current taxes on a lump-sum withdrawal at ordinary income tax rates. If your income tax bracket is higher now than it is in retirement, you could be losing a sizable chunk of the lump sum in taxes. To help cover this tax liability, a lump-sum payout from a pension that is not directly rolled over is subject to a 20% mandatory tax withholding. That is, the employer will withhold 20% of your pension distribution before it is paid to you. If you overpay taxes or decide to roll over the money within 60 days, you will get back the excess taxes you paid as a tax refund.

Early Withdrawal Penalties or Reduced Payouts

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You may be given the opportunity to cash out the vested amount of your pension as a lump sum in advance of when you plan to retire. But withdrawing your pension before retirement can cost you. If you are under 59.5 years of age when you receive the lump sum, a 10% early withdrawal penalty may be applied to you unless:

  • You took the distributions in regular, equal payments after you were separated from employment.
  • You have a permanent disability.
  • The withdrawal was made after the death of the plan participant.
  • You cash in a pension at age 55 or over because you were separated from employment.

Delaying the start of pension withdrawals makes sense even if you choose the annuity option. You may be able to retire at age 60, but that doesn't mean you have to start your pension at 60. Many pensions—although not all—offer substantially higher payouts if you begin benefits at a later age. You might be leaving money on the table if you haven't analyzed the payout options and you start your pension early.

Even if you have to withdraw from your savings a little to make up for the delay, waiting might still be the more attractive option to increase payouts and reduce your risk of running out of money in retirement.

The Bottom Line

The risk of outliving or otherwise depleting a one-time pension payment means that are very few good reasons to cash out your pension as a lump sum besides a below-average life expectancy. In addition, withdrawing your pension before retirement, while possible, can often result in unplanned taxes and penalties.

More often than not, monthly payouts offer a better deal when they're viewed over your lifetime. However, you should consider your retirement income needs, life expectancy, spousal benefits, and taxes when evaluating the benefits and consequences of the lump-sum or annuity pension option.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.