When one retires from a company or other organization with pension benefits outside social security, several options may be available. One is to take all of the benefits in a lump-sum payout. This option is not only the one most often selected, but could be the most beneficial for minimizing income tax and maximizing total income.
Lump-sum benefits paid out in total within one year may be taxed under favorable 10-year averaging rules. If you take out a partial benefit from your pension or profit-sharing account, lump-sum payout with 10-year averaging is no longer available as an option.
Under 10-year averaging, all pension and profit-sharing benefits (they must be combined) are totaled and divided by 10. The income tax rate applicable to the one-tenth amount is figured as a single person even though the recipient normally files a joint return. The tax is then multiplied by 10 for payment that year.
The 10-year averaging provisions avoid a spiked income tax. Ordinarily, five-year averaging is available for any peak income received in one year. Once the income tax is paid on the lump sum, no further tax is due. When after-tax lump-sum proceeds are invested for income or growth, further income from those funds is subject to tax unless invested in tax-free bonds.
A second option is to roll over all or partial pension benefits into an individual retirement account (IRA) to avoid an immediate tax liability. A rollover IRA for receiving pension benefits is not limited to the usual $1,500 each year. However, pension benefits must be rolled over into one or several separate IRAs rather than into an existing IRA for sheltering normal income.
Funds must be rolled over into an IRA within 60 days of receipt. If pension benefits include stock or other securities, they may also be rolled over into the special IRA, provided the exact securities received are rolled over.
Aside from the advantage of deferring income taxes on benefits by rolling them over into an IRA, you gain flexibility and a continuation of tax-free earnings. If your rollover IRA permits self-management, you can put your money into a wide range of investments according to your own planning.
Usual IRA limitations apply. You cannot withdraw funds from a rollover IRA before age 59 1/2 without penalty. And, you must begin withdrawing funds by age 70 1/2. All funds when withdrawn from an IRA are subject to tax at ordinary income rates along with other income for the year. Presumably, by the time you begin withdrawing funds from your IRA, you are retired, and other income will likely be less.
If you elect not to roll over funds into a self-directed IRA, you may achieve some diversification by setting up two, three, or more IRAs with different investment objectives. You could, for example, choose a rollover IRA at a bank or savings and loan with funds deposited in certificates of deposit, a growth mutual fund offering IRA accounts, an income mutual fund programmed for income or other options.
A third option is to convert pension benefits into an annuity either by using the funds to buy an annuity from an insurance company or electing a pension payout over your lifetime with a possible lesser benefit for your surviving spouse. Either of these options provides no flexibility and once started cannot be reversed. Generally, annuities in the US will be at fixed terms and will provide no hedge against inflation. Company payout plans sometimes offer a small inflation indexing, but check to be sure.
Investing funds in a Swiss annuity has provided some protection against inflation in the past, as the exchange of Swiss francs for dollars has offset the loss of dollars buying power. Whether this will continue in the future is problematic, as Swiss inflation is also increasing.
If you have the option and know what you can or want to do with the funds, I generally suggest accepting a lump-sum payout and paying taxes on the 10-year averaging option.