One of the most difficult pre-retirement decisions that a client may be faced with is whether to accept a lump sum option from his or her pension plan. While these clients are lucky to have access to a pension, it is entirely possible that the pension funds may constitute the bulk of their retirement savings—meaning that deciding between a lump sum and an annuity option can be critical to their future financial health.
Fortunately, the IRS and Treasury have recognized that it is not necessarily beneficial to force participants to make an all-or-nothing choice between an immediate lump sum and an annuity stream that could last a lifetime. New regulations can encourage plan sponsors to offer a third option that provides income security for life, but also gives clients access to the lump sum of cash they might find attractive—and because clients are likely to choose at least a partial lump sum payout, an advisor’s role in helping them manage these funds becomes even more important.
The New Split Distribution Option
The final regulations have modified the minimum present value requirements that apply to defined benefit plans in order to permit plan participants to split benefits between both a lump sum payment and monthly annuity payments without causing the plan to lose its qualified status. The IRS released these regulations because it found that the current rules encouraged individuals to choose a lump sum option, rather than the lifetime annuity option that would protect against the risk of outliving retirement savings.
The Treasury regulations provide that the present value of any accrued benefit paid to a participant as a lump sum may not be less than the amount calculated using a specified applicable interest rate and mortality tables. The final regulations provide that this rule can now be applied only to a specified portion of a participant’s benefit, as though that were the entire benefit. Any remaining benefit can then be offered to the participant as an annuity, using the plan’s typical calculations for determining the monthly amount.
Alternatively, the plan can distribute a lump sum that satisfies the rule with respect to that payment, while the remaining portion also satisfies a minimum requirement where that portion (expressed as the normal form of benefit at normal retirement age) may not be less than the excess of (1) the participant’s total accrued benefit over (2) the annuity payable in that form that is actuarially equivalent to the lump sum payment, determined using the applicable interest rate and mortality table.
Benefits of Splitting the Pension Distribution
The new rules should encourage defined benefit plan sponsors to offer an option that includes both a lump sum and a stream of monthly annuity payments that will last for the participant’s lifetime. Under the previously existing rules, many clients chose the lump sum option in order to receive an instant infusion of cash without considering the need for a steady stream of income during retirement.
A lump sum option allows the pension plan sponsor to manage the risks associated with managing the plan and paying benefits, so represents a trend that is likely here to stay. However, plan participants often fail to consider whether they will be able to appropriately manage the lump sum of cash once they have opted out of the annuity option (which would require the plan sponsor to manage the funds).
The split distribution option essentially gives clients the best of both worlds while still allowing pension plan sponsors to reduce their risk exposure. Clients can roll the lump sum payment portion into an IRA in a trustee-to-trustee transfer in order to avoid immediate tax liability, or can purchase a commercial product (such as an annuity with a long-term care rider or death benefit) to accomplish a variety of goals that extend beyond securing a monthly income payout.
While a client who chooses a split distribution option may secure a monthly income stream for life, it remains important that the client make informed investment decisions with respect to the lump sum option—as these funds may still play a crucial role in the client’s future retirement income security.
Originally published on Tax Facts Online, the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.
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