As you inch closer to the golden years of retirement, planning and preparing for your retirement income can be overwhelming. How much income will you need? How much should you withdraw at a time? Where do you even begin?
Start by assessing your income sources, including Social Security, retirement accounts, and a pension plan. Pension plans are employer-sponsored retirement plans that provide income for employees once they retire.
If you’re lucky enough to have a pension plan, you’ll need to understand how to leverage your benefits effectively so you can achieve your financial goals in retirement. In this blog, we’ll review pension options and provide strategies you can implement to maximize pension benefits.
Understanding Pension Options
A pension plan requires the employer to contribute, but depending on the type of plan, the employee may also be allowed to make contributions. There are two main types of pension plans: Defined-benefit and defined-contributions:
Defined-benefit plan: With this pension plan, the employer guarantees the employee will receive a specific monthly payment for life after retiring. The payment is not dependent on the value of the investment, but rather is calculated using a formula based on an employee's total earnings and years of service.
Defined-contribution plan: In a defined-contribution plan, the employee makes pre-tax contributions and the employer is able to match those contributions if they so choose. Contributions to this plan grow tax-deferred until retirement. Popular defined-contribution plans include 401(k)s and 403(b)s. The ultimate value of the retirement benefit depends on the performance of the investments. Once you retire, you receive the accumulated balance as a lump sum or monthly payments
There are also other variations of pension plans that combine features of defined-benefit and defined-contribution plans, including cash balance and hybrid pension plans.
Maximizing Pension Benefits
Not every company offers pension plans, so if you’re offered one, it’s critical to take full advantage of it. There are several ways you can maximize your pension contributions during your employment:
Take advantage of employer matches: If your employer offers a matching contribution, make sure to contribute enough to take full advantage of that benefit. Employer matches are essentially free money, so you don’t want to waste that opportunity.
Maximize your contributions: To get the most out of your pension plan, contribute the maximum contribution if you’re able. For example, for 401k plans in 2024, the annual contribution limit is $23,000.
Leverage catch-up provisions. Some pension programs may allow catch-up contributions that give employees the ability to contribute more to their pension fund, often if you’re age 50 or older. If you have this option available to you, take advantage of it! The more you can contribute in the lead-up to retirement, the better.
Ask questions: Even if you’ve been contributing to your company’s retirement plan for years, if you have questions about contribution limits, vesting, eligibility, or payout options, reach out to the human resources department. It’s better to ask now than be sorry later.
Pension Payout Options
Understanding the payout options of your pension plan will help you better plan for retirement. You have two options: lump-sum or annuity payments. A lump-sum distribution is one-time payment that reflects the current value of your pension. In comparison, an annuity distribution is a fixed monthly payment. Let’s break it down a bit further:
Pros of lump-sum and annuity distributions:
Choosing a lump sum payment provides flexibility in managing retirement assets and allows you to have more control over your money. You can invest it, move it to another retirement account, or cash out.
With an annuity distribution, you can count on a check every single month. Knowing that you’ll have guaranteed income in retirement can be a significant weight off your shoulders. If you choose an annuity distribution, you will have 3 options:
Single-life annuity payments: This option generally offers the highest monthly benefit, but the payments end once you die.
Period-certain payouts: These payments will continue for a specific period—5, 10, or 20 years. If you die before your term expires, the payments will be transferred to a designated beneficiary.
Joint-and-survivor option: These payments account for your lifetime plus the lifetime of another person, typically your spouse or other designated beneficiary.
Cons of lump-sum and annuity distributions:
While a lump-sum distribution allows you to control your money, the downside is that it’s only a one-time payment—not a regular monthly payout like an annuity distribution. So it’s a massive responsibility on your part to manage your money wisely and budget as needed. If you choose to invest the lump-sum funds, there’s no guarantee the funds will grow—if the market fails, so will your investment.
Annuity payments are a great option for those needing guaranteed monthly retirement income, but inflation can impact your earnings. If inflation is high, you will have less buying power because those dollars will be worth ‘less’. Annuity payments are also considered taxable income (which we’ll get to in the next section).
Tax Considerations
Taxes always find their way into every financial equation, but there are different tax implications for lump-sum payouts and annuity payments.
If you opt for the lump-sum distribution, you can roll over the funds into a Traditional IRA, but you will be taxed when you take the money out. If you don’t roll it over, you’ll be subject to a hefty single tax bill on the entire payment.
With annuity payments, you will be subject to taxation for each year based on the value of the payments you receive. However, remember that annuity payments are significantly smaller than a lump-sum distribution, making them less likely to impact your tax bracket.
Seek Out Professional Guidance
Before choosing a pension payout option, make sure you have all the facts. Do you know what options your plan allows? Do you need monthly retirement income to fund your daily lifestyle? Do you have large amounts of debt? Are you able to manage your retirement money responsibly?
Consult with a financial advisor or pension specialist to get the answers you need. Retirement income isn’t something you want to guess at—you need an expert working with you to ensure that you can live out your dream retirement.
Maximize your pension and begin on a more confident path to retirement planning with our team at Emergent Wealth Advisors. Learn more about our modern approach to financial planning, and get in touch with us here.