Should I Roll My Pension Lump Sum into My 401(k) or IRA?
Taking a pension lump sum takes careful consideration. If you decide to take a lump sum, you’ll have to decide whether you transfer your lump sum pension payout into your 401k or your IRA. The decision to take a lump sum can’t be reversed, so take it seriously.
Many different factors come into play when we’re sorting through this decision. Pension payout calculations, tax considerations, and personal goals all matter. Also, your investment style and habits around money are very important as well.
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Understanding Your Pension Lump Sum
A pension lump sum is exactly what it sounds like – a single payment event all in one “lump” sum of money. Instead of having your pension spread out into even payments, what we call annuitized payments, you get everything all at once. Then you take responsibility for creating your own retirement income from the money you received as a lump sum.
There are many different factors influencing the size of your lump sum. To start, you have to understand what the lump sum is based off of. Your lump sum payment is simply the estimated value of the total payments you would have received from your pension. The calculation usually starts with your final average earnings (FAE) to determine your estimated annual or monthly payments.
Then the plan sponsor or actuary will make what’s called a net present value calculation using your estimated payments and the current GATT rate to figure out your lump sum payment. There’s a little more to the calculation as well, such as estimated life expectancy, but this is the basic process.
Tax Considerations and Implications
Many plans give you the option to roll your lump sum into a retirement account such as a 401k or an IRA. Many will also allow you to take some, or even all, of your lump sum in cash – we generally advise against taking cash out without careful consideration. If you take a cash payment, you’ll be taxed on the amount distributed to you.
Another thing to consider is the type of account. For instance, if you’re trying to transfer into a Roth IRA, this would be considered a Roth IRA conversion. Once again, you’d have to pay all the taxes on the money converted. In both cases, you might end up paying way more taxes than you need to.
The Benefits of Rolling Over into a 401(k)
Most employers will also offer a 401k along with your pension plan. There are some unique considerations for a 401k. Often these plans will have limited choices of funds, but also typically have lower fees.
The main advantages of rolling your pension lump sum into a 401k are bankruptcy protection (limited for IRAs as well), continued deferred taxation, and simplicity.
One of the main advantages of a 401k is the potential for tax-deferred growth. In other words, you got a deduction from your income in the year you contributed funds, and then have to pay the taxes when you withdraw later. Essentially, you got to “kick the tax can down the road” until retirement or until you hit required minimum distributions (RMDs).
The other added benefit of rolling your lump sum into your 401k is the simplicity of having everything in one place. However, this can be accomplished with an IRA as well. Investment options vary by employer (plan sponsor), but you’ll generally have a limited number of lower-cost funds to invest in.
There are some disadvantages to rolling your pension lump sum into a 401(k). The biggest one is the number of investment options and higher expense ratios compared to some larger fund providers. For most individual investors, this isn’t a major issue.
The Advantages of Transferring into an IRA
An individual retirement account (IRA), also referred to as an individual retirement arrangement, is a different type of retirement account. Just like a 401k, there are bankruptcy protections, but there is a limit (currently $1,512,350 as of April 1st, 2022). However, you can still defer paying taxes until withdrawal.
Reasons for Rolling Your Pension Lump Sum into an IRA
The biggest reasons for transferring to an IRA versus a 401k are for broader investment choices, more control over your investments, and the potential for lower fees. Also, if you have more than one retirement account from several employers, it might be easier to transfer them all into the IRA versus your 401k.
It is important to note the difference between a Roth and a traditional IRA. As mentioned earlier, you have to make sure you’re transferring between the same types of accounts (e.g. Roth to Roth, Traditional to Traditional), or you could end up creating a taxable event. Your lump sum pension has not been taxed yet, so if you transfer to a Roth account or a regular bank account (anything other than a retirement plan like a 401k or IRA), you’ll have to pay taxes on it.
The other advantage of transferring to an IRA is the ability for your financial planner to help you manage your account more easily. Also, your IRA can be at any number of financial institutions – not just whichever brokerage your employer uses. This allows you to keep everything all in one place to simplify your financial life.
Comparing the Two Options
At the end of the day, there’s minimal difference between rolling your pension lump sum into your 401k or an IRA. Your personal situation and preferences carry the most weight. The bigger decision is whether you chose a lump sum over other pension payout options.
Pros and Cons of 401(k) Rollovers
The biggest pro for your 401k is probably the simplicity. If you’re planning on keeping your 401k with the company it’s currently invested with, it might make sense to roll into the 401k. Also, if you’re already familiar with, and like, how your 401k is set up, then this potentially cuts down on some paperwork and learning a new company or system.
As for cons, some 401k’s have some different rules when it comes to withdrawals, partial transfers, etc. Also, if you’re working with a financial planner, it might prove difficult or impossible for them to manage the funds inside your 401k.
You might not want your funds in your 401k if you want your financial planner to be able to make trades on your behalf or rebalance your portfolio. If they’re not able to get access, you might have to sit on the phone or make the trades yourself when you need to do trades or other account maintenance.
Pros and Cons of Rollovers to an IRA
One of the biggest benefits of moving your money into an IRA is the flexibility you’ll gain. You can invest in virtually anything inside your IRA. Also, you may find the fees to be lower too.
It’ll likely be much easier to allow your financial planner discretionary access to place trades and other account maintenance on your behalf. It may also be simpler to implement a Roth conversion strategy with your funds in an IRA as well.
The downsides of rolling over to an IRA are pretty minimal. If you’re not planning to also roll your 401k over to the IRA, this could add some unnecessary complexity. However, you can overcome this pretty easily.
Other Factors to Consider
There are many other factors to take into consideration. These may include:
- Your current and future tax situation
- Investment preferences and risk tolerance
- Estate planning and beneficiary considerations
- Assessing the need for ongoing financial advice and management
There’s no one-size-fits-all solution. Your individual circumstances are going to be the most important factor.
Making an Informed Decision
So how do you decide what to do? We’re maybe a little biased but seeking advice from a financial professional is very helpful. We know this because we’ve seen the difference having peace of mind around big financial decisions can make.
Nobody wants to worry or wonder if they made the right decision. And unfortunately, there’s no way to go back after the fact. This is why getting a second set of eyes from a financial professional can be so impactful.
How NextGen Wealth Can Help
At NextGen Wealth, we walk you through our COLLAB Financial Planning Process™ to get the whole financial picture and help you fit all the pieces into place. We plan around the most important variable – you.
The importance of a comprehensive retirement plan can’t be overstated. Simply put, people who have a plan and stick to it do far better. As a matter of fact, your increased financial wellbeing could help you live longer too.
If you want to learn more about how you can optimize your retirement savings and pension options, schedule your free retirement checkup today.
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