How to Handle a Plump Payout After you decide which way to take your retirement money -- in a lump sum or in monthly checks -- the real homework begins.
(MONEY Magazine) – SO YOU SERVED YOUR time, built up your pension credits, religiously stashed a part of your check in the company savings plan and tended it wisely all these years. Now comes the gut-wrenching part: deciding how to take the money. At stake is probably the bulk of your retirement wealth. And since most choices open to you are irrevocable, if you choose wrong you are stuck with the consequences for the rest of your life. Observes Paul Westbrook of Watchung, N.J., a financial planner and retirement specialist: ''Of all the decisions people face at retirement, this one causes the most panic.'' Unless your situation is unusually straightforward, you are well advised to have a financial planner or accountant help you wrestle with the numbers and keep you from tripping over the tax laws. Together you might consider the following questions: Should you take your payout as a lump sum or an annuity? If your only company retirement plan is a pension, this decision has probably already been made for you. That's because most pensions pay benefits only in the form of a monthly annuity, which means equal monthly payments for the rest of your life; about one in five allows employees to take a lump sum instead. You are most likely to face the choice if your retirement package includes a capital- accumulation plan such as profit sharing or a 401(k). Though such plans normally pay benefits as lump sums, your company may let you convert your account balance into an annuity. And even if your savings plan requires you to take a lump sum, you can always use the money to buy an annuity from an insurance company. With an annuity you don't have to worry about blowing your retirement money on a bad investment or spending it all before you die. The annuity is guaranteed to last as long as you do. On the other hand, even with moderate inflation of 5% or so, fixed monthly payments will decline in purchasing power over the years. A 5% annual price rise will halve the real value of your checks after only 14 years. If you take a lump sum, however, you could put a portion in growth investments to preserve the purchasing power of your assets. Also, you may lean toward a lump sum if you want to leave money to your heirs. In converting your benefits to a lump sum, a pension plan's administrator calculates the amount it would take to pay you a check every month for the rest of your expected life, as determined by actuarial tables, assuming the money earns a particular rate of interest, currently around 8%. But pension payments stop at the end of your life (or your surviving spouse's), not at the end of the actuarial life expectancy assigned to you at retirement. Thus an annuity turns out to be a bargain if you manage to live longer than average, while a lump sum wins out if you die shortly after you retire. So if you are chronically ill you should consider taking a lump sum; conversely, if you or your spouse are descended from a long line of nonagenarians, you might lean toward the annuity. If you're somewhere in between, read on. Note too that in calculating lump-sum conversions, employers use unisex life expectancy tables, which understate women's life expectancy. All else being equal, that makes an annuity a better deal for a woman than for a man. Interest rates can also determine whether a lump sum or an annuity is more advantageous. The higher the rate the plan's actuaries assume it can earn, the smaller the lump sum needed to pay a benefit. For example, in July 1984, when interest rates were around 10.5%, a pension of $1,000 a month for a 60-year- old man translated to a lump sum of $93,000. In March 1988, when interest rates were 8%, the same benefit produced $109,000. Many pension managers assume a conservative interest rate at the beginning of the year and stick with it. Thus in a year of rising interest rates, a lump sum offered by your plan late in the year could be disproportionately large. One simple way to tell would be to ask your life insurance agent how large an annuity benefit you could buy with the lump sum your pension is offering. ''To be competitive, an insurance company has to change its interest-rate assumptions frequently to match prevailing rates in the economy,'' explains Norm Clausen, a partner in the Fort Lee, N.J. benefits consulting firm Kwasha Lipton. So if interest rates are rising, you might be able to obtain a higher monthly payment from an insurer's annuity than from your pension, in spite of the insurer's sales charges and profit margin. If you want an annuity, what kind should it be? The most common annuities are life only, which pays you a certain monthly amount until your death; joint and survivor, which assures that if you die first your spouse will continue to receive a certain amount until he or she dies; and life and period certain, which pays benefits for your lifetime or for a specified period -- 15 years, say -- whichever is longer. The option you choose will affect the size of your monthly checks. Life-only annuities pay the largest pensions but stop once you die; the other options continue to provide checks for your beneficiaries at the cost of reducing your income by 10% to 15% during your lifetime. One possible compromise: select the life-only option and buy a life insurance policy. Then when you die and the pension payments cease, the insurance benefits will provide for your spouse. (Under federal law, a married person cannot choose the life-only option without the written consent of his or her spouse, so to make the insurance tactic work, get a notarized waiver of the joint-and-survivor option from your spouse.) Fred Munk, a Westport, Conn. retirement planner, cites the example of a 63- year-old manager who must choose between a life-only pension of $30,000 or a $25,700 joint-and-survivor pension with his 63-year-old wife as beneficiary. Were he to select the life-only option and then buy a whole life policy that has an initial face value of about $130,000 -- level-premium whole life is required because term insurance becomes prohibitively expensive at older ages -- the couple could pocket an extra $50 a month in retirement income after the cost of the insurance. Upon his death, his wife would get the same income as under the joint-and-survivor pension option. Not every whole life policy will do, warns Munk. To hold the cost down, he says, insist on a policy with minimum cash value buildup and a face value that decreases over time. ''As your beneficiary ages,'' he says, ''he or she needs less life insurance proceeds to provide the same income because his or her life expectancy is growing shorter.''
Which tax option should you take for a lump sum? A lump-sum distribution need not be very large to push you into the top tax bracket of 33%, which is triggered by a taxable income of $43,150 if you are single, $71,900 if you are married. Luckily, the tax code lets you use one of two tax-saving tactics. First, if the lump sum makes up at least 50% of the value of your interest in a specific plan, such as a 401(k), you can roll the distribution over into an Individual Retirement Account within 60 days after receiving it. Your money will compound tax-free until you make withdrawals, which will be taxed as ordinary income. ''In my experience, if you don't need to begin withdrawing money from the IRA for three to five years, the rollover is almost always the better choice,'' says John Connell, head of financial planning at the accounting firm Touche Ross. Second, you can use a tax-saving device called forward averaging, if you meet these conditions: 1) your payout represents your entire interest in a plan; 2) you have participated in the plan for at least five years; and 3) you are 59 1/2. (If you are 52 or older in 1988, you get a special break: you don't have to wait until you reach 59 1/2 to use forward averaging. But if you aren't at least 55, you will be socked by a 10% early-withdrawal penalty.) If your lump sum makes it past all these checkpoints, it is taxed as if you had received it over five years instead of all at once. This is known as five- year forward averaging. If you were born before Jan. 1, 1936, you can choose an even more capacious break, 10-year forward averaging. In both cases, you pay the total tax in the year you get the money but at a much lower rate than if the sum were taxed like the rest of your income. For example, with five-year forward averaging, a married couple with $30,000 of other income who received a lump sum of $150,000 would pay $30,398 in taxes -- an effective tax rate of 20% -- instead of the $45,867 (31%) they would pay under ordinary tax tables. With 10-year forward averaging, you figure your taxes at 1986 rates, when brackets were as high as 50%. The couple in our example would pay a tax of $24,570 on their lump sum -- an effective rate of about 16.4%.
People over age 52 who participated in their employer's pension plan before 1974 have yet another option: they can elect to have the portion of the sum attributable to their pre-1974 contributions taxed as capital gains -- at the top 1986 rate of 20%. (Your company benefits department can tell you exactly how much qualifies as capital gains.) These taxpayers can then use five-year or 10-year forward averaging for the rest of their payout. $ What methods give you the least tax? If none of your distribution qualifies as capital gains, the answer is easy: 10-year averaging if your payout is less than $473,700. Above that amount the lower tax rates used in five-year averaging outweigh the greater bracket-lowering power of 10-year averaging. In the end, the only way to choose between forward averaging and a rollover is to project the consequences of both into the future and see which alternative rewards you with the most after-tax income. But the numbers do not always have the final word. Larry Silver, a tax partner at the accounting firm Peat Marwick, recalls making all the tax calculations and actuarial assumptions for a 65-year-old client with a retirement lump sum. The bottom line: roll it over into an IRA, postpone withdrawals until 70 1/2 and come out decisively ahead beginning at age 88. The man was not impressed. Recalls Silver: ''He said, 'What do I care about having more money at 88? I want to enjoy it now.' ''
BOX: LUMP SUM VS. ANNUITY
To decide how to take your retirement money, you should project the financial consequences of each option. This table, put together with the help of Paul Westbrook, a retirement planner in Watchung, N.J., reviews the choices open to a couple, both 65, who are faced with a $250,000 benefit. The first option would be to leave the money in the pension plan, which would pay them an annuity of $24,000 ($17,280 after taxes). The payments would continue as long as they lived; however, with 5% inflation, by the time the couple reached age 75 the check would be worth only $10,346 in 1988 dollars. The remaining four options all require the couple to take the $250,000 as a lump sum and invest it either in a tax-free bond fund paying 7.3% a year or a taxable bond fund yielding 9%. In each case, they could then withdraw $17,280 after taxes in the first year and increase the payout by 5% a year to counteract inflation -- so that at age 75 they would still receive the same amount of money in 1988 dollars that they did at age 65. If the couple needed income right away, they could pay the tax up front, taking advantage of the favorable 10-year forward-averaging rate (explained in the accompanying story). Invested in the tax-free fund, the remaining money would last them to age 78. Two less desirable options -- paying the initial tax at the less favorable five-year averaging rate and postponing the tax by rolling over the entire sum into an IRA -- would both exhaust the couple's capital when they reached age 77. The best course, if the couple can let the money grow untouched for five years, would be an IRA rollover. In that case, the sum -- invested in the taxable fund -- would last to age 86.
BOX: Benefits: Terms to remember -- Asset-accumulation plan: An investment account set up by the employer, contributed to by the employer and employee, and managed by the employee. -- 401(k): The best of the capital-accumulation plans. Lets you stash away a tax-deferred $7,000 a year. Employer often makes matching contributions. -- Life-only annuity: A pension that provides you alone with a certain amount until your death. -- Joint-and-survivor annuity: A pension that keeps paying out until both you and your spouse die. -- Life and period certain annuity: A pension that continues for your lifetime or a specified period. -- Forward averaging: A tax-saving device that allows you to pay income tax on a benefit payout as if you had received the money over five or 10 years.
BOX: HOW DOES YOUR COMPANY PLAN STACK UP?
As the accompanying story explains, wise management of your employer's retirement plans will improve your eventual payoff, but nothing beats having a generous package to begin with. To help you judge yours, we asked employee- benefits experts what features distinguish a solid gold handshake from a brass imitation. Their answers: -- A GENEROUS PENSION FORMULA. Pension plans usually compute your retirement benefits by multiplying a percentage of your salary by the number of years you worked for the company. As a rule, the most generous formulas, known as final- pay pensions, use your salary during your highest-paid three to five years. According to a survey of 812 large and medium-size employers by the benefits consulting firm Hewitt Associates of Lincolnshire, Ill., about one in six companies bases its pension payout on your average salary over your entire career, a formula that tends to penalize employees who rise through the ranks. In practice, however, many of these companies voluntarily update their plans to make them competitive with final-pay pensions. A typical final-pay formula would award you retirement income equal to 1% of your average salary during your three to five highest-paid years times the number of years you spent with the employer. If the pension gives you 1.5% or more for each year of service, be pleased; if you get 2% or more -- as do employees of Morgan Guaranty and PepsiCo -- feel free to brag about it. On the other hand, if your plan follows a career-average pay formula, a typical multiplier of 1.5% would produce only about as much retirement income as a three-quarters of 1% to 1% final-pay pension, because the salary used in the formula would be smaller. Few companies using career-average-pay plans, however, go much higher. Two that do: Ford, which employs an accrual rate of 2%, and American Honda, which uses 2.5%. If you are tempted to leave work before your company's standard retirement age, note that most formulas will reduce your pension. If you have been with your employer for 30 years, for example, three out of four companies surveyed by Hewitt would trim your benefits -- by 4% a year on average -- if you left before age 62. -- ADJUSTMENTS FOR INFLATION. Less than 5% of pension plans guarantee periodic inflation raises to retirees. And though many companies voluntarily increased pension payments during the roaring inflation of the 1970s, the practice has faded in recent years. ''Whether it's a new tough corporate philosophy or simply reduced fear of inflation, very few companies are giving increases any more,'' says Robert Heitzman, a partner of the benefits consulting firm Kwasha Lipton in Fort Lee, N.J. If your employer, like AT&T, Kodak and Lockheed, has boosted retirees' income in the past four years -- a comparatively low- inflation period -- take it as an encouraging sign. -- MORE THAN ONE PLAN. Even a long-term employee can expect his combined pension and Social Security benefits to replace only about 40% to 60% of his salary, so it helps to have a supplementary capital-accumulation plan, such as profit sharing or a 401(k). ''If a pension provides the basic income, these plans allow you to live in the style you choose in retirement,'' says benefits consultant Linda Holleman of Booke & Co. in Winston-Salem, N.C. According to Department of Labor statistics, only about two of every five packages offer at least two plans, but multiple plans are far more prevalent among large employers. Hewitt Associates found that 92% of such companies backed employees with at least a pair of plans. About one in six toss in two capital- accumulation plans, such as a 401(k) and an employee stock ownership plan. -- A 401(K) WITH MATCHING CONTRIBUTIONS. In more than two-thirds of the 401(k) plans in the Hewitt Associates survey the employer offers to chip in a certain percentage of your contribution, most commonly 50 cents on the dollar. One in five of them matches you dollar for dollar, however, and one in 100 gives you more. Two magnanimous matchers: National Westminster Bank, which hands over to its employees $1.50 for every dollar they contribute, and Bankers Trust, which matches two dollars for one.
CHART: Initial Net sum Income* Income* Balance at Age when Option tax invested at age 65 at age 75 age 75 income ends
Pension $0 $0 $17,280 $10,346 $0 death
Lump sum with 10-year averaging 50,770 199,230 17,280 17,280 85,330 78
Lump sum with five-year averaging 60,110 189,890 17,280 17,280 66,436 77
IRA rollover with immediate 0 250,000 17,280 17,280 108,882 77 withdrawals
IRA rollover with no withdrawals for 0 250,000 0 17,280 372,865 86 five years
*In after-tax 1988 dollars, assuming inflation of 5% a year
CREDIT: NO CREDIT CAPTION: NO CAPTION DESCRIPTION: Financial data on several retirement plan options.