Pension plans are quickly becoming a perk of the past. However, if you are fortunate enough to have one, you may be facing a challenging payout decision. To help you avoid an irreversible mistake, Ethos Capital Advisors is breaking down the key differences between an annuity and a lump-sum distribution to allow you to assess your options.
Lump-Sum vs. Annuity: What’s the Difference?
A lump-sum distribution is a one-time payment from your pension administrator. With this payment type, investors receive a large sum of money, giving individuals the flexibility to spend however they wish—whether reinvesting, paying outstanding debt, or jetting off on a dream vacation.
On the other hand, an annuity is a contract designed and issued by insurance companies that offer annuitants a guaranteed income stream during retirement. Beneficiaries with an annuity plan collect a fixed quantity, receiving regular incremental payments.
Here’s an example to illustrate how each payment operates: You’ve just won $10 million playing the lottery. If you decide on taking your winnings as a lump-sum payment, you’ll be required to pay income taxes for that year on your $10 million winnings, placing you in the highest tax bracket.
If you collect your prize as an annuity, you’ll receive consistent payments over an agreed-upon period. Rather than collecting the entire $10 million in one year, your annuity payment might be $300,000 a year. Although you still have to pay income taxes on the $300,000, you can avoid having to pay a higher tax bill at the end of the year.
Annuity Plans
An annuity is customizable and can generate lifelong income. These payments offer advantages, such as security, funds to cover unexpected expenses and eliminate the fear of running out of funds in retirement.
Types of Annuities
Annuities come in 2 primary forms— fixed and variable. Fixed annuities offer a fixed interest rate on your investment during the agreed-upon timeframe, providing you with a set periodical payout. Variable annuities allow the contract owner to receive larger payments provided that the investments made on the annuity fund do well. On the contrary, smaller payments will occur if investments do poorly. Variable annuities involve investment risk so be sure to speak to a qualified professional to discuss the best option for your unique situation.
Disadvantages:
- Surrender Charges– If you want to withdraw your money from a contracted annuity, you may be faced with surrender charges as high as 20% within the first few years of owning the contract.
- Tax Penalties- If you are under the age of 59½, you may also incur a 10% tax penalty in addition to surrender charges.
- Inflation- Annuities offer lifetime income. However, not all annuities offer inflation-adjusted income. You may lose some of your purchasing power over time.
- Opportunity Cost- Opportunity cost refers to the missed opportunities that may become available to you, like stock investments and favorable interest rates, by having your funds tied to a contract. Annuities, however, are not investments. If your long-term goals are conservative, consistent income in retirement will mitigate second guesses.
Lump-Sum Payments
Lump-sum distributions offer more flexibility and greater financial control. This payment might be an attractive option for those looking to invest in financial vehicles with higher risk to earn higher returns.
Disadvantages:
- Higher Taxes- If you decide not to roll your lump-sum distribution into a traditional IRA or other qualifying plans, you will incur a large tax bill from your distribution.
- Running Out of Money– The average retirement lasts around 30-years. With life expectancy growing longer, it’s possible to run out of retirement money if not managed appropriately.
- Management Complexity- Although a lump-sum distribution grants you investment flexibility knowing how to manage the new fund is where the complexity lies. Without proper counsel, management may quickly become a time-consuming, risky task.
Key Takeaways:
- An annuity offers investors the benefit of receiving a stable income, which may add up to a larger sum compared to a lump-sum distribution.
- Annuity payments are guaranteed for the rest of your life, regardless of how long you live.
- Lump-sum payments provide financial flexibility, giving you the freedom to spend and invest how you see fit.
- A lump-sum payment attracts tax at once, whereas the annuity attracts tax at a much lower rate.
Contact ETHOS Today and Find a Retirement Plan that’s right for you!
If you need assistance with choosing the right retirement plan, Ethos Capital Advisors can help! We offer comprehensive retirement income planning to help you find a financial strategy that best aligns with your individual needs.
Schedule a meeting and speak to a financial adviser today about developing a tax-smart strategy that’s right for you.
