When you retire, you may have a choice as to how you receive your retirement income. While you may take payments, a partial lump sum pension distribution is almost always an option. Before taking a partial lump sum, you should understand how it affects you and how it could be beneficial for you.
Read More: Retirement: Benefits & Disadvantages
Pros and Cons of Taking a Partial Lump Sum at Retirement
When you take a partial lump sum from your retirement accounts at retirement, you may use this money for any reason. If your debts are overwhelming you, a large lump sum of money may help you to pay off this debt. You should examine your expenses and determine whether you are better off paying down debt than trying to service the debt throughout your retirement years.
With a partial lump sum withdrawal, you may also be left with enough money in your retirement account to draw an income that will pay for your remaining expenses.
Reduce or Eliminate Future Tax
By taking a partial lump sum of money, you eliminate future taxes on your retirement savings. The amount of money you withdraw will be subject to income tax, but may be rolled over from your retirement account into a Roth IRA to avoid future tax. The rollover involves taking a lump sum distribution and redepositing it into a new retirement account within 60 days.
Alternatively, you may invest the lump sum of money you withdraw into tax-free bonds, giving you a tax free income.
Read More: Taxes on Lump Sums for Disability
Reduce the Required Minimum Distribution
By taking a partial lump sum of money, you reduce the amount of money subject to the IRS' required minimum distribution rules. All retirement accounts that contain tax deductible or pretax contributions are subject to a required distribution at age 72. As the account balance grows larger, more income must be taken and more tax must be paid.
Control Over Investment Options
By taking a partial lump sum at retirement, you have more control over your investment options. If you have a pension, for example, you may only receive a set amount of money per month; this amount is dictated by the annuity that the pension uses to distribute payments. In a 401(k) plan, you are limited to the mutual funds available in the plan. With an IRA, you are limited to what the brokerage offers inside of the IRA.
When you take a lump sum payment, you are be able to put your money into investments that may not be available to you through your brokerage or insurance company. These investments may include limited partnerships or alternative investments like rental or income properties. If you are good at analyzing the market, it may be smart to invest the money elsewhere.
Risks and Long Term Effects
MetLife did a study with participants that took their retirement in a lump sum and other individuals who took an annuity. Among the participants, those who took the lump sum were clean out of funds, on average, in 5.5 years. Another correlation among the participants was the risk factor. Lump sum was taken out mostly by risk takers more than by conservative savers.
It is important to have a plan when you take that lump sum so your retirement isn't strained.
I am a Registered Financial Consultant with 6 years experience in the financial services industry. I am trained in the financial planning process, with an emphasis in life insurance and annuity contracts. I have written for Demand Studios since 2009.