Big Money, Big Risks: Should You Take a Lump-Sum Pension Buyout Offer?

lump sum pension buyout
lump sum pension buyout

When times are tough, it often feels as if the only shot you'll ever have at making ends meet is winning the lottery. If you're one of the fortunate workers with a pension, and you're offered a big lump-sum payment in exchange for it, you might well feel like your lottery wishes have been granted.

And the odds of it happening are somewhat better than that lottery windfall: Ford (F) and General Motors (GM) alone made such offers to more than 130,000 of their workers earlier this year.

In reality, though, how you handle an offer from your employer to buy out your pension benefits may be the biggest money test you'll ever face. If you decide to take the money and run, then you'll have another tough task ahead of you: putting it to work in the best way possible.

What Not to Do

The first trap that many workers fall into when they're handed a lump-sum pension payout is to treat it like ordinary savings. That can be the most costly mistake you'll ever make.

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Most pension distributions are treated the same way as withdrawals from a retirement account. So if you just take the money and put it into a regular bank account, you could end up having to pay taxes on the entire amount, potentially losing hundreds of thousands of dollars of your hard-earned pension to Uncle Sam.

To avoid that, all you have to do is roll over your lump-sum payment to an IRA. That way, you'll preserve the tax advantages of your retirement money. You'll still have to pay taxes when you take money out of the IRA, but you'll get to decide when the time is right. By spreading out withdrawals over time, you'll likely pay a lot less in taxes in the long run.

Invest Smarter
By taking a lump-sum distribution, you're essentially saying that you think you can do a better job investing your money than your former employer. The challenge is figuring out how to do that.

There's no one perfect investing strategy that will work for you. Because everyone's different, it's essential to come up with a plan that matches your specific needs. But here are some general guidelines to consider:

  • You need this money to last the rest of your life. If you gamble on a hot stock and things turn out badly, you don't have anything to fall back on.

  • You have to take some risk. Unfortunately, safe investments like short-term bank CDs that used to pay reliable income of 4% to 5% now pay less than 1%. Unless you've got a huge pension, that won't come close to meeting your living expenses. The recent popularity of dividend stocks comes in part from this hunger for income, but as we all found out four years ago, even safe-looking stocks won't always protect you from market collapses.

  • Protect yourself from a personal financial crisis. The benefit of having a monthly pension is that it's guaranteed for life. Even if you take a lump sum, you can lock in monthly income with a portion of your assets by buying what's called an immediate annuity. In exchange for money up front, an insurance company will guarantee monthly payments for the rest of your life, with options for payments to go to a surviving spouse or other family members after your death if you choose.

  • Consider your other financial resources. For many workers, a lump-sum pension payout represents their entire retirement nest egg. But if you've been prudent enough to save money for retirement elsewhere, whether it's through a tax-favored retirement account like an IRA or 401(k) or simply in a regular bank or brokerage account, then you have more options in considering how to integrate a lump-sum payment into your overall financial plan. If you have substantial savings, you won't have to take as much risk with your lump-sum payment in order to have a comfortable retirement.

Taking on responsibility for investing a lump-sum pension payout is a big commitment. But if you make the right moves, it can also be the most rewarding thing you'll ever do with your money.

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Fool contributor Dan Caplinger expects to get no pension payouts. He doesn't own shares of the companies mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of General Motors and Ford, as well as creating a synthetic long position on Ford.