In this article, we will discuss whether you should take a lump sum or annuity at retirement. We will review the common reasons for early retirement and the 6% test, as well as other financial factors to consider. We will also cover how to utilize your retirement package after making your decision.
Common Reasons for Early Retirement
Studies indicate that health is the main factor in early retirement. Job separation and job loss can also be highly influential reasons, but forced retirement in this category can be alleviated by finding new jobs. If you face involuntary retirement with compensation, you may have to choose between a lump sum or a retirement plan. This can be a difficult choice, but there are steps you can take to feel confident in your decision. The first step is to determine the best option for you. There are some ways to do this, one of which is the 6% test.
6% Test
Many people who take the lump sum invest at least part of it so that the money can grow and enhance their retirement savings. The 6% test is a way to measure whether the lump sum is sufficient to grow at a rate similar to retirement payments.
To determine if your retirement passes the 6% test, multiply the monthly retirement payment by 12. Divide this number by the total lump sum, then multiply by 100. For example, if a retiree is required to choose between $1,000 per month for life starting at age 65 and a lump sum of $160,000 today, the monthly retirement payment of $1,000 multiplied by 12 equals $12,000. Divide $12,000 by $160,000 and you get 7.5%. The individual in this scenario would need to earn about 7.5% annually on the $160,000 to replicate the steady monthly payments of the retirement plan. Earning 7.5% per year consistently is a challenging task, especially since retiree investments are on a relatively short timeline. This means that the monthly payment may be a better deal in the long run. Overall, it is more realistic to expect that your lump sum will earn less than 6% annually in investments. If you can earn less than 6% and still achieve a profit greater than your retirement plan payments, the lump sum may be the better option for you.
Other Financial Factors to Consider
Calculations are an important step, but they are just the first step. After doing the calculations, there are several additional factors to consider before deciding between a lump sum or retirement plan. Look at the age when the monthly retirement payments start versus the time when the lump sum is paid out. How long can you realistically expect to live? This may seem a bit dubious, but it is a crucial part of retirement planning. The longer you live, the more valuable the lifetime monthly retirement plan becomes. Look at the details of your retirement plan. Does it rely only on your life and stop after your death, or does it continue to cover your spouse’s lifetime? How stable is the company that is promising you retirement? If you are concerned about the bankruptcy of the retirement company, see if the plan is backed by the Pension Benefit Guaranty Corporation (PBGC), which helps ensure your income. Evaluate your entire financial portfolio, including any additional forms of retirement savings. Then, see if this amount is sufficient to cover any unexpected emergency payments. If not, this could be additional benefits in choosing the lump sum.
Methods
Using Your Retirement Package
Once you have a good idea of whether to take the lump sum or the pension plan, consider some common ways that people use their retirement funds. These factors shouldn’t be the primary basis for your decision, but they can help clarify your retirement plan.
Check if your retirement package includes healthcare. If you are not eligible for health insurance yet, find out if healthcare expenses will be covered by the retirement plan and set aside money for healthcare if they are not covered. If they are, this is an expense you won’t have to worry about in early retirement.
Another option is to use the lump sum to pay off or reduce debt. Utilizing the cash available from the lump sum to pay off debts can be a good step. You can pay off your mortgage, your car loan, or eliminate your monthly credit card balance so you can reduce your overall expenses.
Another option if you are granted early retirement with compensation is to save the lump sum and invest it while finding a new job. Unplanned retirement doesn’t mean you have to stop working completely. If you can find a job in your field or work part-time doing something you love, your retirement package is money that can be added to your savings. You can also use it to cover your monthly needs, while your new job helps you build greater wealth or fund retirement activities.
Ultimately, you should make a decision that suits your financial situation and personal needs. You may need to consult a financial advisor for tailored advice for your individual situation. Be sure to make the choice that makes you feel comfortable and confident about your financial future.
Source: https://www.thebalancemoney.com/should-you-take-a-lump-sum-or-pension-1289928
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