Considerations of a Pension Buyout

If you are faced with the opportunity to receive a pension buyout or lump sum payment of your pension from a current or former employer, consult an experienced financial advisor that can assist you with better understanding your options.

A look in any newspaper’s obituary section you will see women and men living into their 80s and 90s. This increase in life expectancy has caused many employers to freeze or terminate traditional pension plans, also known as defined benefit plans and have replaced them with defined contribution plans, such as 401k and/or profit sharing plans. This switch from defined benefit plans to defined contribution plans also shifted the liability (cost) of living longer (longevity risk) from the employer to the employee.

While younger and/or newer employees may only have a 401k for retirement savings purposes, older employees or those with more years of service may be a participant in a pension plan that is ‘frozen’. A pension plan is considered frozen if employees can no longer earn benefits under the plan and/or the plan no longer accepts contributions from the employer and/or the employee.

Although a pension plan may be ‘frozen’, the company still maintains an obligation to pay the benefits for every participant in that plan upon a participant attaining a certain age or years of service as prescribed by that plan. This obligation or long-term liability remains until the last person (or beneficiary in some instances) in the plan expires. As a means to remove this long-term cost, some employers may offer a pension buyout.

The company offers to pay the employee or former employee a one-time, lump sum payment, in order to eliminate the ‘risk’ of that employee living so long that they receive more in pension payments than was contributed to the plan for them. As people are living longer, more and more companies are facing this reality and offering a pension buyout is a common way that companies are addressing this issue. A pension buyout allows them to say, 'if you live to age 100, the risk or cost of funding your retirement is on you, the employee', instead of the company.

Exact terms of pension buyouts vary from company to company, but they often allow the following options: lump sum payment, payments starting once you reach a certain age, or rollover to an IRA.

If you decide to receive your pension buyout as a lump sum, your (former) employer is required to withhold 20% of the total pension buyout amount. Please know that there is no 20% tax rate; the marginal tax rates are 10%, 12%, 22%, 24%, 32%, 35% or 37%. If you’re in the 24% tax rate or higher, consider the mandatory 20% withholding as a down payment on your taxes and you could potentially owe more. If you’re younger than 59½ when the lump sum payment is made, you may be subject to an additional 10% early withdrawal penalty.

Taking a pension buyout as a lump sum payment could also result in a person being in a higher tax bracket because the total amount of the distribution is added to all other income. So a person that would normally be in the 24% tax bracket, depending upon the amount of the lump sum payment, could have total income that places them in the highest tax bracket at 37%. Adding that to the 10% early withdrawal penalty, it is possible that nearly 50% would be owned in taxes and penalty.

Pension buyouts may offer the option of doing nothing and waiting until a certain age and payments will begin and continue for the remainder of your life. While there could be several payment options, life payments provide the highest monthly payment because if you suffer a premature death, the company isn’t obligated to continue payments to beneficiaries.

You may also be offered the option of rolling over your pension buyout to an IRA (Individual Retirement Account). A direct rollover from your pension plan to an IRA does not trigger a tax bill. Your retirement assets enjoy the benefits of continued tax-deferral and may even have the potential for future growth which could result in greater income in retirement.

Call today 901-312-9166 or complete our contact form (click here) to schedule a no-cost consultation to discuss which option best suits your individual situation.