What is the tax impact of getting a lump sum versus routine payout of retirement?

Ralph
00:00:00

I've got a question for you today. Have you ever wondered if there's a smarter way to receive your retirement payouts?

What if I told you there's a difference between a lump sum and an annual payout and that could significantly impact your financial future? Well, stick around, because today we're going deep into the tax implications of retirement. We're talking about payouts.

And trust me, you don't want to miss this.

Narrator
00:00:23

Welcome to the Ask Ralph podcast, where listening to an experienced financial professional with over 30 years of experience can help you make sense of confusing questions, current headlines and industry trends about taxes, small business, financial decision making, investment strategies, and even the art of proper budgeting. Ask Ralph makes the complex simple by sharing his real world knowledge from a Christian perspective with all things financial.

Now here's your host, Ralph Estep Jr.

Ralph
00:00:52

Yesterday we talked about the nine unexpected costs of selling your home, and if you missed it, you missed a great deal. So I'm going to strongly encourage you to go back and listen to it.

We uncovered some hidden expenses that if you don't know about them, they're going to catch you off guard when you're trying to sell that house. And trust me, it's knowledge like that that could save you thousands of dollars. Now let's get to today's listener question. This one comes from Ryan.

Ryan writes this. Hey, Ralph, I've been a faithful listener of your show for years, and I'm so grateful for the wisdom you share.

I'm approaching retirement age, and I'm faced with a big decision. My company is offering me the choice between a lump sum payout or annual payments for my retirement. I'm not sure which option to choose.

Can you help me understand the tax implications of each? Also, how might this affect my ability to budget and invest for the future? Thank you so much for your guidance, Brian.

I just want to start by thanking you for your questions.

It's those questions that fuel the show, and this particular question is something a lot of people face as they approach retirement, and it's absolutely crucial that you understand the implications of your choice. Like I said, I want to remind you, if you got a question like Ryan, don't hesitate to send it in.

Because after all, answering questions is what the Ralph ask Ralph show is all about.

You can submit those questions at justaskralph.com. Ryan's question really touches on a fundamental principle we find in the Bible, and that comes in the book of Luke, chapter 14, verses 28 and 30. And it says this, for which of you desiring to build a tower does not first sit down and count the cost, whether he has enough to complete it.

Otherwise, when he has laid a foundation and is unable to finish it, all who see it begin to mock him, saying, this man began to build and was not able to finish. That's a rough one.

But this passage reminds us of the importance of careful planning and careful consideration, especially when it comes to significant financial decisions. And listen, retirement planning is by its very nature a significant financial decision.

Let's take this biblical wisdom that we learned, and let's apply it to Ryan's question. And I want to share a bit of a story that's going to show you how this impacts in the different options you have.

And let's just tell you, I got two clients, and we'll call them Joe and Fred. Now, Joe and Fred were both retiring from the same company, and they faced that same choice. Now, their choice is a little bit different.

Their company basically said to them, listen here, guys, here's what you can do. You can either agree to sign up for a monthly payment from our, what they call defined benefit plan, and I'm going to get into details with that.

But basically you could sign up to get a monthly check from us for the rest of your life, or we'll give you the cash value of that right now. You can take it and do what you want with it. Now, Ryan's situation, I don't really understand exactly what he's doing, but it's similar to that.

So let's talk about how this impacted Joe and Fred. So Joe, like I said, we got Joe and Fred. He decided to take a monthly pad. He said, you know what, been working for this company for a long time.

I'm cool with that. But now, Fred opted for a lump sum. And then what he did was he rolled that into his IRA, which he would be able to manage himself.

Now, listen, I'm going to give you a warning right now. It's vital that you make sure it's rolled over or it's going to become income in the current year, and that will be a huge tax hit.

So thing number one, if you don't take away anything else today, if you have this option with your employer, you definitely want to make sure that if you're going to take that lump sum one time payout, that you're going to work with a broker and roll that into some retirement plan, that you don't take all that money in the current year because you will lose 50% of it in tax. So you might be thinking, Ralph, at first glance, hey, money is money, right? What's the big deal?

Well, let me tell you, there are differences, and these differences were eye opening. So let's talk about Joe first.

Now, Joe was the one that elected to have his monthly payout, and he liked that because he found himself in a comfortable routine. He was used to getting a paycheck, and now this was pretty much the same way it was before.

So he knew exactly how much was coming in, made budgeting a breeze. It was almost like he said to me, said Ralph, it's like I'm still receiving a paycheck. And that consistency gave Joe peace of mind.

That was important to him. He didn't have to worry about market fluctuations.

It was all invested in the company's retirement plan, those market fluctuations that could affect his entire retirement nest egg, because only a portion, whatever he took out each month, he could reinvest, but only a portion that was invested at any given time. He was banking on the corporation or banking on the business where he worked. Now, look, I want to be clear about something.

I'm assuming this is a traditional pension plan, not a 401K or other investment, because that could be different. But I'm assuming in this case, this is a company sponsored pension plan.

Now, unfortunately, not a lot of these exist anymore, but I've got a lot of people that call me and ask questions that are in these things. Now let's talk about the other guy, and that's Fred. Now, Fred, on the other hand, received a substantial lump sum when he got that offer.

He said, you know what I'm going to do? He says, I'm going to go ahead and take the cash value of that.

So the company figured out, okay, if you take that lump sum, we're going to give you x number of dollars. And Fred liked that because he felt, you know what? He's, I don't know about this company. I want some flexibility.

And he wanted to have control over his money. And see what that did was that removed his reliance on the financial health of his former employer because he had the money.

Now, he had it with his investment. But you got to understand something, that also came a greater responsibility, because now Fred all of a sudden had to be disciplined about budgeting.

But at the same time, he had the opportunity to invest a larger portion of his money and maybe he could earn higher returns. But of course, with those high returns, it also exposed them to more market risk.

Now, here's where things get really interesting, and that's the tax implications. So let's go back to Joe. Now, Joe was the guy that selected the monthly payments.

They were taxed as regular income each month, kind of like getting a w two or a paycheck. So his tax burden was spread out evenly throughout the year. It was easy to manage.

He told his, I, his former employer, hey, out of each of my pension checks, withhold this much in federal tax, withhold this much in state tax. It was simple. It was really kind of set it and forget it. Now, on the other part, Fred.

Now, Fred had to face a different situation, because not only did Fred have to manage all this money, but he also had to manage those withdrawals. He had to decide, how much can I take from my investments to live my life? But he needed to make it last for his entire retirement.

Joe didn't have that concern because Joe was going to get that same monthly check regardless of what happened. Now, I don't want you to think that Fred didn't have options, because he did. So Fred hired a financial advisor.

Sort of what I do for clients, I don't do investment decisions, but I help them strategize. And the particular guy that Fred had hired, we worked together, and they strategize his withdrawals.

And one of the cool things they found is that by spreading some of his lump sum distributions, they could actually reduce his potential tax burden by spreading them over two years. So let me give you an example of what I'm talking about there. So Fred decided he needed to buy a new car.

Now, Fred could have went to his broker and said, you know what, broker? I want $30,000 on December 15 so I can buy that car.

And what that would have done is that would have put all of that income into that current tax year.

But what Fred did, and this was key, him and I worked together with his broker, and instead of withdrawing the entire amount from the retirement in one year, he split the withdrawal across December of one year, in January the next. So in my example, he wanted to buy that car. He wanted to get $30,000.

But what we did was we had him take 15,000 on December 31 of year one and then the other 15,000 on January 1 of the following year. And what did that do?

That simple move helped him avoid pushing his income into the higher tax bracket, because we didn't have all of that income in one year. So that's one of the benefits of Fred doing that lump sum and putting that money in his own account.

See, Joe couldn't do that because Joe was going to get that monthly check regardless if he needed the money. If he didn't need the money. Excuse me, but then you might be wondering about the investment value differences between these two approaches.

That's really what we're talking about here. So it's not only that decision upfront, but how about the investment value? Joe's monthly payout meant he had less money to invest at any given time.

He was just getting what he needed as he went. But of course, like I said, that also meant he was less vulnerable to market downturns now, as compared to Fred. Now, Fred had his own investments.

He had the potential for higher investment returns. He was at the point of being able to make those decisions. He could decide, what am I going to invest in? Do I want to invest in this?

Do I want to be conservative? Do I want to be risky? All those things. But again, like I said, that came with that risk. So here's the powerful conclusion from Joe and Fred stories.

You're not going to like my answer, but it's the truth. There is no one size fits all answer. The truth is the choice depends on your individual circumstances.

It depends on your risk tolerance and your financial goals.

Let me summarize this, because I know there's a lot to cover here to make it more clear with the monthly payout, that monthly payout is going to provide that steady income.

The remaining funds continue to grow tax deferred, and you got less risk of depleting those savings quickly because you don't have any control over how much you take. You get what they tell you you're going to get.

Now, from the tax perspective, it taxes ordinary income each year, and you can keep the retiree in a lower tax bracket that way. So you can keep your taxes in a lower tax bracket.

Now, required minimum distributions are usually satisfied because that monthly payout is your, in fact, your requirement of this minimum distribution, unlike if Fred, in our example, who's going to have to worry about that? We'll talk about that in a second. We talk about lump sums.

There is no really an RMD issue because you're going to get that monthly pension check regardless. So let's talk about the other side of that, and that's that lump sum.

Now, what Fred got and what people get when they do this lump sum is they have full control of their investments. It's in their account, it's with their broker.

And like I said, we're assuming that Fred didn't make the bonehead move and take all that money out and pay the tax. Now, I've had clients do that. That's an individual decision.

I don't think it's a wise decision because, like I said, you're going to lose upwards of 40% to 45% of that at the front end.

But like I said, if you do that lump sum now, all of a sudden you've got full control of your investments, and maybe that leads to higher returns if you invested wisely. But the problem with that is you could have a broker that doesn't do their job. You might have poor management, you might have market downturns.

You may take more than you think or more than you really could have taken. And the problem with the tax side of this is those large withdrawals could push the client to a higher tax bracket.

That becomes an issue because the entire sum becomes taxable in the year withdrawn, which could lead to overall taxes being higher. Think about this. If Fred doesn't learn to spread those things out, and let's just say he says, you know what?

I'm going to put it all on red and go to the casino, and he takes $100,000 of that, that's going to put all that income in the current year. So here's the thing that the key takeaways to this, this is the main considerations.

You've got to look at your own financial discipline and your investment knowledge. In Joe's case, he's not a real sophisticated financial guy, doesn't know a lot about investments. So for him, set it and forget it.

Get that monthly pension check and he's happy. You've also got to look at your current and expected future tax rates. You got to look at your life expectancy and your health considerations.

And that's basically when they gave Joe and Fred that decision to make. That was all factored into. That's how they came up with those numbers.

And they said that, Joe, if you take this monthly payment, it's going to be $2,000 a month. But maybe they said to Fred, hey, Fred, if you take this lump sum distribution, we're going to give you $600,000.

So these are all things you got to keep. But the key to this, whichever option you choose, you've got to have careful planning and disciplined execution. That's crucial.

So you might ask, Ralph, what do we learn from Joe and Fred's experiences? So here's a few action steps.

I always like to give you action steps, because if you don't take action, you can hear all the best ideas in the world, but if you don't put them in the practice, you're not going to get anywhere. And it's all going to start with assessing your budget needs, just like Joe and Fred had to do.

Do you prefer that consistency of a monthly payout, or can you manage an annual lump sum or manage when you take your money out? Yes, it all comes down to your ability to budget. The second thing you've got to do, this is an individual decision.

You've got to evaluate your risk tolerance.

Are you comfortable with potential for higher returns that come with more investment control, or do you prefer that safety of a guaranteed monthly income? Now listen, we are making a huge assumption that Joe's company continues to be in business.

They continue to have a good pension system and all that sort of thing. So we're just going to make that the assumption. But Joe is locked into that guaranteed monthly payment.

The third thing you've got to consider, we talked about this from all directions, and that's the tax situation.

This is where I'm going to encourage, oftentimes on the show, I tell you, talk with a tax professional about how different payout options might impact your tax bracket and your overall tax burden. I meet with clients when we do their taxes, or they come in for a consultation or we do a Zoom meeting. We talk about what if scenarios.

What if I do this, Ralph? What if I do that? We talked about that income splitting between two years. I've done that with many clients who have to make a major purchase.

The fourth thing, you've got the plan for flexibility. Just like Fred, you might be able to strategize your withdrawals to minimize those tax impacts, especially for those large purchases.

And number five, and a lot of people lose sight of this one. You've got to think long term.

You got to consider how it's not just your immediate needs, but how your choice will affect your financial situation in ten years or 20 years or 30 years down the road. So, Ryan, I know there's a lot to digest there, but I hope this helps you understand the implications of your retirement payout options.

Remember, Proverbs 21:5 says it encourages us to be diligent in our tax planning. I'm going to encourage you. Take your time, consider your options, and don't hesitate to seek professional advice. I want to speak to you directly.

If you're facing a similar decision, or if you have any questions about managing your finances from a Christian perspective, I'm here to help. Look, these are not easy decisions, and the impact may very well last for the balance of your life well into your time.

And yes, you can make a bad decision. You can make a decision that will put you into a very bad financial situation for the rest of your life.

So I'm going to encourage you to schedule an appointment with me and together we can create a personalized plan to help you better manage your financial life. In this case, we're talking about personal finances. And how do you manage that retirement.

Maybe you're a business owner, you've got some questions about your business finances. Maybe you're looking for ways to grow your business overall. My goal is to help you achieve all your financial goals.

Now you can schedule an appointment by going to askralph.com. When you get there, you'll see a banner ad. It reads, book a call with Ralph. You click on it and yes, there's dollar 150 consultation fee.

But you got to consider that an investment in your financial future.

Because the truth is, the insights and the strategies we'll discuss could save you thousands of dollars in the long run and set you on a path to financial freedom. And you don't want the opposite. And here's my guarantee for you.

If we're unable to build a personalized plan for you, I will refund your consultation fee. I'm going to work with you. I'm going to help you. I want you to move beyond that living paycheck to paycheck feeling.

I want you to stop feeling like you're taking three steps forward only to take four steps back. I want you to achieve financial freedom. I want to help you be liberated from that financial bondage.

And all of it starts with setting up that first call. So I'm going to encourage you to do that. Let's take a quick minute and recap what we've covered today.

We've learned that the choice between a lump sum and annual retirement payout can have significant impacts on your taxes. It can significantly impact your budgeting, and it also, depending upon what you choose, will make a change in your investment opportunities.

We've also seen how careful planning, like spreading large withdrawals across tax years, I think I've hit that three times now, can really help you minimize your tax return. But that's my goal. But most importantly, more than anything else, we've reinforced the biblical principle of diligent planning leading to abundance.

Now tomorrow we're going to be diving into another exciting topic. And that is, what are the seven best investment choices for frugal people?

If you're looking a way to make your money work harder for you while still being mindful of your spending, you don't want to miss it. I got a letter from a listener and they asked me this question and I dug deep into it. So I've got some real good takeaways for you.

So as I close remember this, my passion is to help you achieve your financial success. That's my goal here. I want you to live out your dreams.

I want you to balance that by growing in your faith, because I know working together we can master your finances from a Christian perspective. So as I always end the show, stay financially savvy and God bless you.

Thank you for joining us on the Ask Ralph podcast. And with a simple click to subscribe, we'll invite you back to our next episode.

And remember, financial issues don't have to be complicated, just ask Ralph. The information contained in this episode of Ask Ralph is based on data available as of the date of its release.

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