Avoiding Costly Lump-Sum Pension Pitfalls

For many people, receiving a pension payout in full is the largest amount of money they will receive from a single event. The sudden wealth created by a retirement account disbursement is exhilarating. It is also challenging. And it could be costly.

If you receive a lump-sum payout, you must handle it carefully or you could face not only major tax ramifications, but also endanger the funds' future return.

To avoid such missteps, familiarize yourself with the lump-sum payout possibilities.

Roll Over Options

In most cases, the pension money has been growing tax-deferred during your work years. Now that you are in control of the account, rolling your retirement money into an Individual Retirement Account (IRA) will allow you to continue to shelter the money from taxes.

The preferred rollover option is trustee-to-trustee. Here the tax-deferred payout funds are transferred to the tax-deferred IRA without you taking possession. With such a rollover, there are no immediate tax issues. Just as important, your full pension amount continues to grow tax-deferred without a break. Talk with your financial adviser before the payout and establish the IRA into which your retirement money will be directly transferred.

If you decide instead to keep some or all of your pension payout, you will face immediate tax withholding at a 20 percent rate on the payout. In addition, taking the distribution yourself could bump you into a higher tax bracket. This in turn could cause possible loss of some itemized deductions.

Other Payout Possibilities

If your retirement plan contains appreciated company stock, you could have the option to sell the stock and pay the lower long-term capital gains tax rate instead of the ordinary income rate. This scenario also takes careful planning and execution, so seek the advice of a CPA or a Certified Financial Planner® professional.

Another lump-sum payout often comes with a severance settlement. These payouts usually do not offer the option of tax deferral through an IRA. However, this money can be put toward a taxable investment account, pay off debt or other purposes. In some cases, companies offer an annuity or other life income stream. Carefully analyze the implications on your individual personal and financial situation.

Protecting Your Payout

In addition to deciding how to take your lump-sum pension payout, you must decide how to protect the investment returns on your new asset.

When your employer was managing your retirement account, investment decisions likely were made by either the company CFO or by a professional investment firm.

As recipient of the payout, you should continue to let professionals manage your money. While it is true that many people enjoy investing and have some success, a part-time approach to assets, especially those dedicated to your retirement, is a risky proposition.

Work with a financial adviser and other money professionals who are practiced in managing assets. Our experience has shown that the results are worth the investment.