All employer plans are required to offer you an annuity payout in the form of monthly income. These payments will continue for the rest of your life (in the case of your 401(k), you can surrender the balance to an insurance company that will guarantee payments for life; the amount of monthly payment will depend on the balance in the account and your age). When considering early retirement, the annuity payouts will be smaller, because you have a longer life expectancy. The payments are taxed as ordinary income and don’t qualify for any special tax treatment for federal income tax purposes. Some states tax these payments, and others don’t.
In most cases, annuity payments aren’t eligible to be rolled over (transferred) to an IRA. Rolling over distributions from an employer plan to an IRA avoids taxation. The one exception is if the annuity payouts are for a period of less than 10 years. Note a 10-year payout isn’t less than 10 years. I had a client, Mark Johnson, who learned this lesson the hard way.
Payout options vary among plans, but the following choices are the most frequently offered:
• Life Income: This option will provide an income for as long as you live; however, the pension dies with you. So while life income will give you the maximum monthly income available, there are no benefits available to your heirs.
• Joint and Last Survivor (J&LS): With this option, you’ll receive a pension for life and provide a survivor income for the life of your spouse. This survivor income will usually represent a percentage of your pension income, typically anywhere from 50-100%. But keep in mind your monthly pension will be reduced when you add a beneficiary. The greater the benefit to the beneficiary, the smaller your pension income will be to you.
• Life Income with Guarantee: This option will also provide you with an income for the rest of your life; however, if you die before the end of the guarantee period, the remaining payments left in this period will be paid to your beneficiary. For example: If you died in the 8th year of a 20-year guarantee, 12 years of payments would be paid to your beneficiary. The guarantee periods generally range from 5-20 years. Note, not all pensions have a guarantee clause; they must only offer the life or joint life options. The concern of some retirees is that they elect the life option and then pass away after only receiving a few payments with nothing going to their heirs. The guarantee period is to assure that the heirs will receive something if the retiree passes away soon after beginning distributions.
• Joint and Last Survivor (J&LS) with Guarantee Period: With this option, you may add a guarantee like the one I described above to your J&LS pension. This is an important consideration if you and your spouse want to be sure there’s money payable to your estate in the event of both of your premature deaths.
• Income Drawdown: This option is a variation on the other choices. Here, the pension administrator calculates the present value of what your payments will be over your life expectancy and shows this amount as a lump sum. Each time you receive a payment, this lump sum is reduced until it reaches zero. If you were to die before the lump sum is exhausted, the balance would be paid to your beneficiary.
Though there are a range of annuity payment options available, this approach still has flexibility problems. Let’s say, for example, you choose the J&LS option. Your monthly payment is reduced to cover your spouse if you’re the first to die. What happens if your spouse dies before you? You won’t need the survivor protection any more, but the payment won’t revert to the higher amount. You’ll be paying for a survivor benefit you no longer need for the rest of your life. Even if you were to remarry, you can’t add your new spouse as beneficiary.
Inflation creates another problem for most annuity payments in the private sector. Government pensions usually offer cost of living adjustments (COLA), though they’re not always automatic. Retiring at age 65 with a $3,000 per month pension may be a comfortable income today, but that amount will have the purchasing power of only $1,500 per month in 20 years at an inflation rate of just 3.5%. Your standard of living would erode significantly if you didn’t have any other savings to supplement your income.
Finally, when you submit your pension paperwork, you’re making a decision that will have to last 20 to 30 years. Are you ready to make that kind of decision when you retire? I can’t tell you how many people have sat in my office at retirement and said, ‘Rick, I’m finally retired, and I’m not going to work another day in my life!’ Yet a year later, many of those same people say, ‘Rick, I’m sick and tired of painting the house. I need something to keep my mind occupied. I’ve decided to do some consulting work for my former employer a couple days a week.’ Those people no longer need the same pension income, but they can’t turn it off, and they end up paying tax on it every year because the payments aren’t eligible for rollover.
Case Study: Mark Johnson, Retiree
Mark was a retiree who’d elected a 10-year payout of his pension, since they didn’t offer a lump sum distribution at the company he retired from. He’d been retired for three years when he started doing some consulting work. Since he didn’t need the pension income, he put the payments into his IRA and called it a rollover. But the IRS doesn’t allow these payouts to be rolled over, because the period elected wasn’t less than 10 years.
We had to pull out all of the contributions Mark made and the earnings. The excess contributions were subject to a 15% penalty. His tax returns needed to be amended for the years he didn’t claim the pension income, and he had to pay back taxes with interest. The IRS could have charged a penalty for the back taxes but chose not to, because we caught the mistake and corrected it voluntarily. But the mistake was costly enough as it was.
The moral of this story is: When you’re asked to choose a payout option for your annuity upon retirement, choose wisely! With most retirement plans, this is an irrevocable decision.
