Rolling over a pension plan into an IRA has a number of advantages, including increased investment alternatives, tax savings, greater control over your retirement resources, and withdrawal flexibility. The disadvantages of rolling over into an IRA include the loss of creditor protection, the lack of lending possibilities, and early retirement penalties.
Can a pension be rolled over to an IRA?
Over 90,000 Ford employees must make a critical decision about their pension.
When you retire and have a 401k, the decision is usually straightforward: convert the 401k to an IRA.
There are few exceptions to the norm, such as if they are under the age of 59 1/2 or if they own employer stock, but for the most part, this is the best option.
Pensions normally pay you a monthly income for the rest of your life, with your spouse receiving half of that amount for the remainder of her life. If you don’t want to take an annuity, the only other option is to take a lump sum payment.
The lump sum option allows you to take a large piece of money now and roll it over to an IRA later.
You then have complete discretion over how much retirement income you take each month.
Let’s take a look to determine if rolling your pension into an IRA makes sense.
Before I go any further, I should point out that the lump sum option is not available to all pensions.
Teachers are one fast example that springs to me (at least in my location).
The monthly annuity benefit is the only choice for most teachers.
Financial Strength of Your Company
Choosing between a lifelong income option and a lump sum payment may be as simple as assessing the financial strength of the firm you work for.
Your pension is covered by the PBGC (Pension Benefit Guaranty Corporation), but only up to $54,000 and only if you retire at 65, as I indicated in a previous post “Company is Going Bankrupt, What About My Pension?”
You’re out of luck if you go beyond that.
Any amount of pension that exceeds the $54,000 cap makes the decision to take the lump sum more appealing.
How is Your Health?
Is there a history of disease in your family? If that’s the case, accepting the lump sum and rolling it into an IRA could be the best alternative. If you’re only going to be retired for a few years, what’s the sense of having a steady income for the rest of your life?
My client has a never-married acquaintance who has worked for the same employer for nearly 30 years.
When that person retired, they had the option of purchasing an annuity and receiving monthly payments.
They died abruptly just three months after receiving their checks.
What happened to the rest of the pension payout, by the way?
Because they didn’t have a spouse to pass it on to, everything went back to the company.
They may have chosen another family member to receive the pension or at the very least contributed it to a charity or their church if they had rolled the income into an IRA.
Beneficiary Minded
The majority of pensions are structured so that you (the employee) will get a regular income stream for the rest of your life. Your surviving spouse will receive half of the sum you got when you die. (Some pensions do allow your spouse to receive the full benefit, but you would have had to accept a lower sum at first.)
If your spouse dies before you, you won’t have to pay anything else.
When your spouse passes away, the payment comes to an end with him or her.
If you have surviving children, the pension will not be paid to them.
If you choose to roll your pension into an IRA, you will be able to leave the balance (if any) to your heirs.
They may also be able to stretch the IRA across their lifetime if done correctly.
Lump Sum Pension Payment Vs. Monthly Benefit
The last determinant is “It’s All About the Benjamins,” as the song by Puff Daddy used to proclaim. You should compare the cost of a lump sum pension benefit vs a monthly pension benefit.
Example 1
One of my clients was offered an early retirement buyout. He wasn’t quite 55 yet, so he could begin collecting benefits right away. They were offering a monthly reward of roughly $3000 per month.
He had chosen a lower sum (the $3000) in order for his wife to receive the same amount for the rest of her life. That wasn’t a bad choice, but let’s double-check the lump sum amount.
Because the pension was older and favored tenured employees, the lump sum payment was just around $250,000. I say “only” because, assuming no inflation, the client’s pension would have been fully depleted in little under 7 years, right before he turned 62.
Example 2
Another client had recently turned 62 and was being offered a lump sum payment of $600,000. Not terrible, but let’s have a look at the monthly stipend. The monthly reward was $4,000 per month ($48,000 annually). So far, there hasn’t been much of a choice.
The fact that the client had a 401(k) with the same employment for slightly over $200,000, as well as an adequate emergency fund and no debt, made it very evident.
Furthermore, they had three children to whom they wished to leave an inheritance.
It may make sense to roll over a pension into an IRA if they believe they will never outlive their retirement savings.
Before 59 1/2- In Service Distribution
Last but not least, you do not have to wait until you are formally retired to roll your pension over. You can choose to perform an In Service Distribution once you reach the IRS’s magic age of 59 1/2.
You can choose to roll over your pension amount into an IRA even if you plan to continue working.
Your pension will continue to accrue with your company, and you will have entire authority over your funds once they are no longer in your employer’s possession.
This is also applicable to 401(k) plans.
Making a decision on your pension’s future is a big one. Examine your options several times and obtain advice from a variety of sources. To assist you decide which option is best for you, I recommend consulting with a Certified Financial Planner and a Certified Public Accountant.
Can a lump-sum pension payout be rolled into an IRA?
Yes! If you are faced with a lump-sum payout, you can roll it over into a Traditional IRA or 401(k) and avoid paying taxes or paying an early withdrawal penalty, according to IRS publication 575.
Should I have an IRA if I have a pension?
Yes. If you have a pension, you can contribute to both a 401(k) and a standard Roth IRA. In fact, having all of these accounts is definitely in your best interest to mitigate any potential risk related with pensions. Pensions are supplied by fewer employers these days, as mentioned several times above.
Should I roll over my pension to my 401k?
When an employer announces that the company’s pension plan will be terminated, employees will be given a lump-sum payment. Employees who leave a company with a vested balance in their pension fund are in the same boat.
Employees can roll their pension distributions into a 401(k) or IRA and avoid paying income taxes and early withdrawal penalties at the same time, according to the IRS.
A direct rollover and an indirect rollover are the two options for transferring a pension to a 401(k).
Direct rollover
A direct rollover is the simplest way to transfer a lump-sum pension payment to a 401(k). To perform a direct rollover, you’ll need to have a 401(k) account already set up.
To start a distribution from your pension plan, you’ll need to engage with your employer and supply the relevant paperwork. The administrator of your pension plan will make the direct transfer of funds from your pension account to your 401(k) account as simple as possible (k). Everything is completed within a few business days for you.
Indirect rollover
You can still roll over your pension money to a 401(k) if you don’t already have one (k). You might choose to receive a check for the entire balance of your pension savings.
The only requirement is that you deposit the money into a 401(k) within 60 days of receiving them, or the distribution would be considered a retirement withdrawal and subject to income taxpossibly with a penalty if you are under 55.
The pension plan administrator is required to withhold 20% of the account amount for tax purposes when you take an indirect rollover. To avoid paying taxes and penalties, the IRS requires that you roll 100 percent of your pension into a 401(k). To avoid this, you’ll need to make up the difference from another source, such as a savings account, in order to finish the rollover. Your tax responsibilities for that tax year will be offset by the 20% your employer withheld at the start of the year.
How can I avoid paying tax on my pension?
When you exit most pension plans, your employer is required to withhold a mandated 20% of your lump sum retirement settlement. If you do a straight rollover of those funds to an IRA rollover account or another similar qualified plan, you can avoid this tax impact. If you don’t rollover the entire amount of your lump sum payment, you may end up paying taxes on all or part of your retirement payout.
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment, just like the federal income taxes withheld from your paycheck.
The federal government holds it as a credit against your tax liability for the year in which you received your payment.
When you file your tax return the following year, usually by April 15th, you can utilize that tax prepayment to decrease your tax liability. Alternatively, if you overpaid your federal taxes, you may be entitled to a refund of the taxes withheld in excess.
It is recommended that you contact your investment representative, banker, or new employer’s retirement administrator before agreeing to accept your lump sum retirement payment to prevent the tax hit entirely. With your investment broker or banker, open a rollover IRA account. My firm has set up rollover accounts for a number of people. Next, tell the company’s pension administrator that you’re leaving or have left to route your lump sum payout to your new IRA rollover account or qualifying plan.
You avoid the 20% tax withholding penalty if your lump sum retirement distribution is transferred immediately from one trustee to another without you ever gaining ownership of any portion of the cash.
With a direct rollover, your pension funds are not taxed until you start withdrawing from the rollover account at a later date.
Caution: if you receive a cheque for less than 80% of your retirement funds, you may be forced to pay taxes if you do not take prompt and urgent action.
What will the tax consequences be if the entire rollover is not completed? You can anticipate to pay taxes at your tax bracket rate on any amount of your lump sum retirement payment that is not rolled over within 60 days of receiving your retirement check. Furthermore, if you are under the age of 59 1/2 when you get your retirement payout, you will be subject to a 10% tax penalty on any amount not rolled over within the statutory 60-day period. A failed rollover can be costly for someone who is serious about lowering their tax bill and putting their pension savings to good use.
For example, if your former company withheld $20,000 from a $100,000 lump sum dividend, you’d owe $7,600 in taxes (38 percent tax bracket).
If you are under the age of 59 1/2, you will be subject to an additional ten percent tax penalty of $2,000 if you are under the age of 59 1/2.
With a complete rollover, your tax bill on your $20,000 will be $9,600 instead of “0.”
When you only received 80% of your assets and need to rollover 100% of the payout, how can you achieve a tax-free rollover? The answer is that you must obtain the 20% withheld cash from another source. In other words, the money you rollover must be equivalent to the total amount of retirement funds paid out on your behalf. It makes no difference where that “missing” 20% comes from for rollover purposes as long as you deposit 100 percent of your lump sum retirement distribution check into a rollover account within 60 days of receiving it.
A straight rollover is, of course, the simplest way to avoid paying taxes on your entire lump sum retirement income.
However, if you are faced with a tax bill because you were unable to rollover the entire distributed amount, strive to minimize the tax bill as much as possible.
At the very least, rollover 80% of your lump-sum retirement payment.
Next, try to rollover a portion of the 20% that has been withheld.
Maintaining your pension payout in a rollover account until you reach age 59 1/2 is the key to a tax-free pension rollover.
Alternatively, if you must access your pension assets before then, do it sparingly and judiciously.
Where should I roll over my pension?
Your age has a significant impact on your selection. If you have 10 years or more before retirement and your firm decides to cancel their pension plan, it may be a good idea to rollover your pension balance into an IRA or your current employer’s 401(k) plan. Firstly, since you have the advantage of time on your side and complete control over the account’s asset allocation.
The investment objective of most pension plans is conservative to moderate growth. Rarely will you come across a pension plan with an equity exposure of more than 80%. Why? It’s a pooled account for all employees, regardless of age. Pension plans cannot be susceptible to significant levels of volatility because the assets are required to fund current pension payments.
You have the option of picking an investment objective that suits your personal time horizon to retirement if your personal balance in the pension plan is transferred to our own IRA. If you have a lengthy time until retirement, you have the opportunity to be more aggressive with the account’s investment allocation.
If you are fewer than 5 years away from retirement, choosing a monthly pension payment may not be the best option, but it is a more difficult decision. To replicate that income stream in retirement, you must compare the monthly pension payment to the return you would have to achieve in your IRA.
How do I avoid tax on my pension lump sum?
To prevent paying too much tax on your pension income, make sure you only take the amount you need each tax year. Simply put, the smaller your income is, the less tax you will pay.
You should, of course, take as much money as you require to live comfortably. Having more money than you need and putting it into savings, on the other hand, is less advantageous than getting a paycheck. In most circumstances, it’s advisable to keep money in your pension account until you’re certain you’ll need it.
Using a drawdown program can be advantageous in this situation. Drawdown allows you to adjust your income from year to year, thus saving you money on taxes. For example, if you spend £25,000 one year but only need to spend £20,000 the next, you will save £1,000 in taxes if you just take out what you need. If you earn the same amount of money but don’t spend it, you’ve squandered $1,000.
You won’t have this freedom if you have an annuity, because your annuity income will be consistent year after year. Drawdown, on the other hand, has its own set of dangers. Consult an IFA to determine which option is best for you.
Should I take a lump sum distribution from my pension?
1. Will I need the money for income right away?
A monthly pension may be appropriate if you anticipate requiring monthly retirement income in addition to your Social Security payment and gains from personal resources. Your employer agrees to pay you the same amount of money every month for the rest of your life if you choose this choice. That monthly income is usually fixed and won’t change, which is a benefit because it eliminates surprises. But there’s a catch: some pensions don’t include cost-of-living adjustments, which might help you keep your spending power in the face of inflation.
If a combination of Social Security and personal savings will supply all of your income, rolling over a lump sum into an IRA may be a better option. A direct rollover allows you to keep the money invested tax-deferred while also allowing you to access it when and if you need it. Your nest fund has the potential to keep up with escalating prices during several decades of retirement if you own growth-oriented investments in your IRA account.
Longevity Risk
With a lump payment, you run the danger of outliving the funds, depending on the success of the investment and how much is needed for income. The pension income cannot be outlived.
If you choose the lump sum option, you can invest the money in an annuity to ensure a steady income stream for the rest of your life. The annuity may provide income options that the pension does not. If you need more money, you may be able to accelerate your annuity payments depending on the income choice you choose. Naturally, this will have an impact on your annuity payments in the future.
Inflation Risk
Your purchasing power might be eroded by inflation. Some pension plans provide a cost-of-living adjustment that might help counteract inflation. A fixed lifetime pension income payment, on the other hand, may result in diminished purchasing power. The lump money could be invested to provide recurring income. Depending on the performance of your lump sum investment, the impact of inflation may be reduced. One way to protect yourself from inflation is to invest in mutual funds.
Market and Interest Rate Risk
When paying defined benefit pension contributions, your employer takes the investment risk. When you take a lump-sum pension payment, you take on the risk of investing the money to create retirement income. Market fluctuations and low interest rate conditions can affect the future value of the lump payment as well as your available income.
Default Risk
The employer guarantees the pension income, but only to the extent that the employer is able to make the payments. What is the company’s present and future financial outlook?
The Pension Benefit Guaranty Corporation (PBGC) guarantees the payment of some pension benefits if the employer fails to meet its commitments. The risk is that the PBGC will only insure the benefit up to a specific amount. For further information, go to the PBGC website.
Overall, there are numerous variables to consider before accepting a lump sum pension buyout offer. The lump amount may be appropriate in the following circumstances:
- You believe you can earn a higher rate of return than the one utilized to determine the lump sum.
- You may not require the money or desire more control, allowing you to do things like leave a legacy to your children or donate to your favorite charity.
Otherwise, keeping your pension’s guaranteed income stream may be the best option.
Are pensions considered earned income?
You must have earned money to be eligible for the Earned Income Tax Credit. Earned income comprises all income from employment for the year you’re filing, but only if it’s includable in gross income. Wages, salaries, tips, and other taxable employee remuneration are examples of earned income. Self-employment earnings are included in earned income. Pensions and annuities, welfare benefits, unemployment compensation, worker’s compensation payouts, and social security benefits are not included in earned income. Members of the military who receive excludable conflict zone pay after 2003 may chose to include it in their earned income.
Should I save for retirement if I have a pension?
Your pension should only be one of several tools in your retirement toolbox. Most pensions won’t provide enough income to meet all of your retirement expenses, so you’ll need to save in other accounts as well.
Some traditional pension plans now offer defined contribution plans, such as 401(k)s and 457 plans, which allow you to save more for retirement by putting a portion of your paycheck into a tax-deferred investment account. If that’s the case, consider yourself fortunate and sign up – especially if your workplace agrees to match your donation.
And if you qualify for a Roth IRA, it’s generally the best method to save for retirement. Individuals with modified adjusted gross income (MAGI) of less than $117,000 and married couples filing a joint tax return with MAGI of less than $184,000 can contribute the full $5,500 to a Roth IRA in 2016; if you’re over 50, you can add another $1,000 to make your annual contribution limit $6,500.
How does a pension affect retirement planning?
Social Security, any pension you have earned, and withdrawals or earnings from your collected savings and investments your “nest egg” will all provide you with income in retirement. Receiving an employer-provided pension minimizes the size of the nest egg you’ll need to provide for your family.