If you’re close to retirement, you might find yourself wondering about your pension plan.
Here’s a dilemma you might be facing: Should you go for the monthly payment, or take the lump-sum pension payout in Canada?
The answer is it depends. There are many factors to take into consideration when you make your decision. Things like taxes, your health, how much money you’ll need to live on, and if you plan on leaving anything to beneficiaries after you die.
Each person’s situation is different, so I’ll go over the pros and cons of both scenarios to help you make an informed decision.
A Pension Plan Overview
A defined benefit (DB) pension plan offers its employees a predetermined and guaranteed monthly income for life.
That monthly income is unaffected by the state of the markets and may even include other benefits like health coverage for the participant and their spouse.
Some pensions may even continue payments to the spouse after the participant dies. How much the participant receives is calculated based on complex formulas and often includes factors like the length of time the employee worked at the company.
Pros and Cons of a Lump-Sum Distribution
Taking a lump sum payment, also known as the commuted value of the plan, is enticing. Depending on the years you’ve been with the company, it could be a huge amount.
However, once you choose to take the lump-sum distribution, you can’t change your mind. That’s why it’s important to understand each option and what it means to you and your future.
Pros
- You can gain access to a large sum of money right away. This means you can take control of it and invest how you see fit.
- If you take a lump-sum payment and invest it yourself, you can change your monthly distribution during the course of retirement, unlike your monthly pension payment. So, if your financial needs change and you need more it’s easy to increase your payments. The same is true if you don’t need as much.
- If you die prematurely, there will still be money left for your spouse. You could also name a beneficiary to receive the excess money after both you and your spouse die.
- A lump-sum payment could be beneficial if you suspect your employer won’t maintain the pension due to insolvency.
Cons
- Lump-sum payments are taxable to you, and the tax could be significant.
- Pension plans guarantee a monthly income for life. However, if you take the lump-sum distribution, you no longer have that guarantee. It’s possible your money won’t last for life, depending on how you invest and market volatility.
- Some pension plans come with related health coverage. If you opt-out of the monthly payments, it could affect your health benefits as well.
How Much Tax Do You Pay on a Lump Sum Pension Payout?
If you choose a lump-sum distribution, you can transfer it to the following accounts without incurring any tax.
- Registered Retirement Savings Plan (RRSP)
- Locked-In Retirement Account (LIRA)
- Life Income Fund (LIF)
The tax is deferred on these accounts until you receive any distributions. However, if you don’t transfer the lump sum into a retirement account, you’re on the hook for the tax owed.
Tax is withheld at the following rates:
- For payments up to $5,000 – the withholding rate is 10%
- $5,000 – $10,000 – withholding rate is 20%
- Amounts over $10,000 – withholding rate is 30%
Pros and Cons of Monthly Pension Payments
Just the tax implications of lump-sum payments might convince you to stick with a regular pension payout. Here are some other points you need to think about before deciding.
Pros
- Pension payments are for life. No matter how long you live, you’ll have a guaranteed monthly income.
- Having a regular monthly income means retirees can maintain their spending levels. Receiving a lump-sum distribution gives you more incentive to splurge on items you might later regret.
- Tax isn’t due all at once. Instead, it’s spread out as you receive your distributions.
- You’ll receive an income no matter what’s happening in the market. You are guaranteed a monthly stipend without regard for investment volatility.
Cons
- You will need to pay tax on your distributions for your entire lifetime.
- Your monthly pension amount can’t be changed. If you experience a health crisis or financial setback, you can’t increase your monthly amount. It’s a set amount that stays the same for your entire lifetime.
- If you and your spouse die earlier than expected, there isn’t any money to leave to beneficiaries. That’s a major drawback if you’re looking to pass something down to your children or next of kin.
What To Do if You’re Close to Retirement?
Before you pack up your desk and leave the workforce behind, make sure you talk with your pension plan administrator and consider the following:
- If you’re planning to retire early, how will that affect your pension payments?
- How is your pension payment determined? What factors are taken into consideration?
- How much money is contributed to the plan? What’s left when you start your retirement, and what happens if the company becomes insolvent?
- Does your pension plan include health coverage? What about for your spouse? Is health insurance terminated if you take a lump-sum distribution?
These are only some of the questions you should ask before the big day arrives. In addition, you and your spouse should go over the monthly expenses you incur, along with your projected monthly income. Consider paying off any outstanding debts like credit cards or car loans. Retiring without these expenses hanging over your head gives you a fresh start and peace of mind.
Final Thoughts
Should you take a lump sum pension distribution? The answer is different for everyone and might be right for you if you’re looking to invest the money on your own and want to pass it on to your beneficiaries after you die.
However, the tax implications of lump-sum distributions may make you think twice about it. Before you make the decision, do your own research and talk to trusted advisors.
Every situation is different, and knowing the pros and cons of both will help you make the right choice.
If you’re looking for more information about retirement, check out this planning guide.
