KPMG Pension Insights: What to Know About Lump Sum Distributions

A lump sum distribution is a one-time payment from a pension plan, often offered as an alternative to monthly annuity payments. Choosing this option can have significant financial consequences, affecting taxes, retirement security, and investment strategies.

Making the right choice requires understanding tax implications, long-term financial impact, and recent regulatory changes.

Understanding Lump Sum Distributions

A lump sum distribution gives retirees immediate access to their pension savings, allowing them to manage the funds as they see fit. Unlike monthly annuity payments, which provide a steady income, a lump sum offers flexibility but shifts the responsibility of managing retirement funds to the individual. The decision depends on financial stability, investment experience, and spending habits.

The amount offered is based on the pension plan’s formula, considering years of service, salary history, and actuarial calculations. Interest rates play a key role—when rates rise, lump sum payouts decrease because pension plans use discount rates to determine the present value of future payments. For example, if a plan uses a 5% discount rate instead of 3%, the lump sum will be lower since future payments are valued less.

Market conditions and pension funding levels also affect lump sum availability. If a plan’s funding falls below regulatory thresholds set by the Pension Protection Act, lump sum offers may be limited or suspended. Employers may also adjust lump sum options based on corporate financial strategies.

Tax Implications of Lump Sum Distributions

A lump sum distribution is typically considered taxable income in the year it is received, which can push retirees into a higher tax bracket. For example, if a retiree normally falls within the 22% federal income tax bracket but a lump sum raises their taxable income above $191,950 (for single filers in 2024), they could move into the 24% or even 32% bracket.

One way to defer taxes is by rolling the lump sum into a tax-advantaged account like a traditional IRA or 401(k), allowing the funds to grow tax-deferred. However, failing to complete a direct rollover results in mandatory 20% federal withholding, and if the full amount is not deposited into a qualified account within 60 days, the entire sum becomes taxable. Additionally, if the recipient is under age 59½, an extra 10% early withdrawal penalty may apply unless an exception—such as separation from service after age 55—is met.

State taxes vary. Some states, like Illinois and Pennsylvania, do not tax pension distributions, while others, such as California, impose high state income taxes. Retirees should consider state-specific tax rules when deciding how to handle their lump sum.

Comparing Lump Sum and Annuity Options

Choosing between a lump sum and an annuity comes down to control versus security. A lump sum allows retirees to invest and manage their funds but requires careful planning to avoid running out of money. Poor investment decisions or unexpected expenses can deplete savings faster than expected.

An annuity provides guaranteed income for life or a set period, reducing the risk of outliving savings. Some pension annuities include survivor benefits, ensuring continued payments to a spouse. However, annuities lack liquidity and do not grow with market gains.

Inflation is another concern. Most private-sector pensions do not include cost-of-living adjustments (COLAs), meaning fixed annuity payments lose purchasing power over time. A retiree receiving $3,000 per month today may find that amount significantly less valuable in 20 years. Those opting for a lump sum can invest in assets that offer inflation protection, such as Treasury Inflation-Protected Securities (TIPS) or dividend-paying stocks, to help maintain purchasing power.

Impact on Retirement Planning

Taking a lump sum shifts the responsibility of income management from the pension provider to the retiree. Without structured payouts, individuals must ensure their funds last throughout retirement while accounting for market fluctuations, withdrawal rates, and unexpected expenses. Financial modeling tools, such as Monte Carlo simulations, can help estimate the likelihood of sustaining a desired lifestyle under different economic conditions.

A well-diversified portfolio is key to balancing growth and stability. The sequence of returns risk—where early losses in retirement significantly impact long-term wealth—makes withdrawal strategies like the 4% rule or dynamic spending models essential for preserving capital. Additionally, Required Minimum Distributions (RMDs) from tax-deferred accounts, which begin at age 73 under the SECURE 2.0 Act, must be factored into long-term planning to avoid penalties and optimize tax efficiency.

Regulatory Changes in 2024

Recent regulatory updates have affected how lump sum distributions are calculated and taxed. Changes in interest rate assumptions, pension funding requirements, and tax policies have altered the financial landscape for retirees considering a lump sum payout.

Interest Rate Adjustments and Pension Calculations

The IRS updates segment rates used to calculate lump sum distributions annually. In 2024, higher rates have led to lower lump sum payouts for many retirees. Since pension plans discount future annuity payments using these rates, an increase in interest rates results in a lower present value for lump sum offers. For example, a retiree eligible for a $3,000 monthly pension might have received a $500,000 lump sum in 2022 when rates were lower, but in 2024, that amount could be reduced to $450,000 due to higher discounting. Retirees must weigh whether locking in a lump sum at current rates is beneficial or if waiting for potential rate declines could yield a higher payout.

Legislative and Compliance Updates

The SECURE 2.0 Act introduced changes to Required Minimum Distributions (RMDs) and catch-up contributions, which impact tax-deferred accounts and lump sum planning. Pension plan sponsors must comply with updated funding requirements under the Pension Protection Act, which may affect whether lump sum options remain available. Some employers have reduced or eliminated lump sum offerings due to stricter funding rules, requiring retirees to reconsider their withdrawal strategies. The Department of Labor has also increased scrutiny on pension risk transfers, ensuring that plan participants receive adequate disclosures before making lump sum elections.

Strategies for Managing Lump Sum Distributions

Effectively managing a lump sum distribution requires a structured approach to preserve wealth, minimize taxes, and ensure long-term financial stability. Without a clear plan, retirees risk misallocating funds, leading to shortfalls later in life.

Investment and Asset Allocation Strategies

Properly investing a lump sum is necessary to generate sustainable income while managing risk. A diversified portfolio that includes equities, fixed income, and alternative assets can help balance growth and stability. Some retirees use a bucket strategy, dividing funds into short-term, medium-term, and long-term investments. The short-term bucket holds cash or bonds for immediate expenses, the medium-term bucket contains balanced assets for stability, and the long-term bucket is allocated to stocks or real estate for growth. This approach reduces the likelihood of selling investments at a loss during market downturns.

Withdrawal Planning and Risk Mitigation

Determining a sustainable withdrawal rate is key to avoiding premature depletion of funds. While the 4% rule is a common guideline, retirees may need to adjust based on market conditions and personal expenses. Dynamic withdrawal strategies, such as reducing withdrawals during market downturns or using annuities for a portion of income, can enhance financial security.

Insurance products like longevity annuities or long-term care insurance can help protect against unexpected healthcare costs. Additionally, tax-efficient withdrawal sequencing—such as drawing from taxable accounts first before tapping tax-deferred assets—can help minimize overall tax liability.