Pension lump sum or monthly annuity?

Many pension plans let you choose how to take your benefit. You can take a monthly check for life, or a single lump sum that you invest and spend yourself. The choice is usually permanent. Once you pick the lump sum, you can't go back to the monthly check.

There's no answer that suits everyone. The right choice depends on your health, your other income, whether you're married, and how much market risk you're willing to carry. This guide shows how to put the two offers on the same footing.

What each option gives you

The monthly annuity pays a fixed amount for as long as you live. If you're married, the default is usually a joint-and-survivor form. Your spouse keeps receiving part of the check, often 50%, 75% or 100%, after you die. Choosing a larger survivor share lowers the starting check.

Most private pensions don't rise with inflation. A check that looks generous at 62 buys much less at 85.

The lump sum is a one-time payment of the pension's present value. The plan works it out from your monthly benefit, mortality tables and current interest rates set by IRS rules. When interest rates are higher, lump sums are smaller, because each future dollar is discounted more.

You can roll the lump sum into an IRA and pay no tax until you withdraw it. Then it's your money to invest, spend and leave to heirs. It's also your job to make it last.

Step 1: work out the implied payout rate

Divide the yearly pension by the lump sum. This tells you what rate the plan is offering for life.

Grace is 62 and single. Her plan offers $2,000 a month for life with no inflation increases, or a lump sum of $310,000.

• Yearly pension: $24,000
• Implied payout rate: $24,000 ÷ $310,000 = 7.7% a year, for life

Now compare that with what it would cost to buy the same income from an insurer. Suppose an insurer quotes Grace $6,300 a year for life for each $100,000 she pays. Buying $24,000 a year would cost about $381,000. The pension's lump sum is $71,000 less than that.

In other words, the monthly pension is worth more than the lump sum on the open market. Getting a quote is free, and it's the quickest test there is.

Step 2: find the break-even age

If Grace takes the lump sum and withdraws $24,000 a year, how long does it last?

If she lives past those ages, the pension pays more in total. The pension also keeps paying if markets do badly, which the lump sum doesn't. A 6% return isn't something she can count on, especially while withdrawing.

Inflation changes the comparison

Grace's pension has no cost-of-living increase. If prices rise 3% a year, her $2,000 check buys about what $1,107 buys today after 20 years. With the lump sum, she could withdraw less at first and raise withdrawals with inflation. That's a fairer comparison than matching the pension dollar for dollar.

Step 3: think about your spouse

For a married couple, the survivor option often matters more than the headline check.

Suppose Grace were married to Hal. A 100% joint-and-survivor pension might start at $1,800 a month instead of $2,000. Hal would keep $1,800 for life if Grace died first. Federal law requires a spouse's written consent before a married participant gives up the survivor benefit.

With a lump sum, whatever is left at the first death passes to the surviving spouse, and then to heirs. Nothing is left if it has all been spent.

When one spouse dies, the household also loses one Social Security check and often moves to higher single tax brackets. See the widow's tax trap. A secure survivor pension can soften that.

Step 4: consider the plan's safety and your other income

A private pension is backed by the plan's assets and by a federal insurance program for private pensions, up to a legal limit. If your pension is far above the insured limit and the plan is underfunded, the lump sum removes that risk.

Your other income matters too. If Social Security and the pension together cover your essential spending, the rest of your savings can take more risk. Without the pension, more of your portfolio may need to stay safe, which can lower its long-run growth.

Taxes on each choice

Monthly pension payments are taxed as ordinary income each year you receive them.

A lump sum rolled directly into an IRA isn't taxed until you withdraw it. If the plan pays it to you instead, it must withhold federal tax, and you have 60 days to roll the full amount into an IRA. You'd need other cash to replace what was withheld. A direct rollover avoids the problem.

If you take the lump sum as cash, the whole amount is taxable that year. That can push you into the 32% bracket or higher and raise Medicare premiums two years later. If you're under 59.5, there may be a 10% additional tax. It doesn't apply if you left the employer in or after the year you turned 55.

A simple way to decide

The monthly pension tends to suit you if:

• your health and family history point to a long life
• you're married and want income to continue for the survivor
• the implied payout rate is above what an insurer would pay you
• you'd worry about investing a large sum, or might spend it too fast

The lump sum tends to suit you if:

• your health is poor, or you're single with heirs you want to leave money to
• the pension is a small part of your income
• the plan's finances worry you and your benefit is above the insured limit
• you want flexibility to spend more early in retirement

Some plans offer a split: part as a lump sum, part as a monthly check. That can give you a floor of income and a pool of flexible money.

How the app handles pensions

Enter a pension as income in your plan, with its start date, its yearly amount and whether it rises each year. For a joint-and-survivor pension, set the survivor share. After the owner's death, the plan keeps paying that share to the surviving spouse.

Pension income is taxed as ordinary income in the federal and state tax calculations. To compare the lump sum, make a scenario with the pension removed and the lump sum added to an IRA. Then compare the two side by side on the Scenarios screen. Both run on the same simulated markets, so the difference comes from the choice, not from luck.

Frequently asked questions

Can I take the lump sum and buy a better annuity?

Sometimes, but rarely. Insurers price in their costs and profit. Unless the pension's implied rate is below what an insurer quotes, the pension usually pays more. See annuities explained.

Does my pension affect my Social Security?

For most private-sector pensions, it doesn't. Rules for some public pensions changed recently, so check with Social Security if you worked in a job that didn't pay Social Security tax.

When should I decide?

Plans usually give you a window of a few months before your payments start. Ask for the lump sum figure, the monthly options and the survivor options in writing, then compare them with an insurer's quote.