A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hi there. David McKnight. Welcome to The Power of Zero show. I’m grateful that you're with us for another week. We're going to have some great exciting things to talk about today, we're going to talk about “should I take a lump-sum distribution for my pension?” we'll get into that and we won't keep you too long today, probably not longer than twelve minutes or so. I'm the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield, all three are available in bulk at powerofzero.com/Books. If you have not yet seen The Power of Zero movie, you can stream that pretty much everywhere movies can be streamed online, so you can stream that, you can gift it, you can buy copies of the DVD/Blu-ray combo pack at thetaxtrain.com. Of course, if you're looking for help in navigating the path to the 0% tax bracket, you can go to davidmcknight.com and we can certainly give you some assistance with that. One other thing that I've neglected to mention these many months is if you want to follow me on Twitter, feel free to do so, I would love it if you followed me on Twitter, it's @mcknightandco.
Let's jump into today's topic which is, “Hey, I got a pension through my work, what are the implications of that pension? Should I take that pension as a stream of income or if my employer gives me the opportunity to take that as a lump-sum, should I take advantage of it?” First of all, let's talk about why companies are even offering you the lump-sum option. A lot of them want to get out from under the financial obligation of paying you or your spouse money until you die. So what many of them are doing is they're saying, “Hey, what's the present value of that future obligation?” In other words, “How much money would you have to have in the bank today that could produce that stream of income for the rest of your life expectancy?” What a lot of these companies do is they give you the opportunity to instead of taking a stream of income either over your life or the joint lives of you and your spouse, they let you take it as a lump-sum and then you can do with that money whatever you want.
First of all, let's talk about the implications of taking it as a stream of income. One of the implications of taking it as a stream of income is that it's going to be a stream of income that's coming out of your tax-deferred bucket. By the way, once you elect that stream of income, once you elect to receive that pension, it is a fait accompli, that means it's a done deal, you can't ever modify the bucket from which that money is coming from, it will always be—regardless of the future of tax rates—it will always be a stream of income, a stream of taxable income, a stream of ordinary income, if you will, that's coming out of your tax-deferred bucket with all of the unintended consequences that go along with that and there are some major unintended consequences.
Now, let me get this out of the way first, I am not suggesting that if you have a lump-sum option that you should automatically take it, there's some math that is involved in it. I'm not guaranteeing that the lump-sum that they give you in exchange for that no longer receiving that stream of income is a good deal because I'm not guaranteeing that it will always be a good deal, but in many cases, it is a good deal so you should do the math on it. Are you confident that the lump-sum distribution that they give you can create that same stream of income for you? That's a decision that you ultimately have to make. I'm not making a sweeping generalization here that you should necessarily take the lump-sum option, I'm just explaining to you what are the tax implications of receiving that stream of income instead of taking the lump-sum option.
When you take the pension stream of income, it counts as provisional income so you can count on, in most cases, having a portion of your Social Security taxed because when you take that stream of provisional income out of the pension stream of provisional income, it'll cause your Social Security to be taxed. In retirement, it will probably fill up the first and second tax brackets, probably 10% and 12% or the future equivalent, probably fill up both of those tax brackets, and anything you take out of your other retirement plans will land right on top of all that other income, and perhaps, even be taxed at 22% or what will be the 25% tax bracket after 2026.
The first implication is for Social Security taxation, this could cause you your Social Security to be taxed. Remember what I've said for years is that we've done the math on this, when 85% of your Social Security gets taxed, which is the situation a lot of people are going to find themselves in, it forces you to spend down all your other assets that much faster. You could run out of money five to seven years faster than people who do not have their Social Security taxed, that's a pretty big deal. The example I give in my workshop is I say, “Hey, what if tax rates went up to 50% and your Social Security gets taxed, you lose $5,000 to Social Security taxation? If tax rates went up to 50%, how much money would you have to take out of your IRA to be able to pay the 50% tax to the IRS, then be leftover with $5,000 with which you could then plug the hole in your Social Security?” The answer is $10,000. The point is you could spend your other assets down a lot faster than you ever thought just in an attempt to compensate for Social Security taxation that’s brought about because you elected the stream of income either over your life expectancy or over the joint life expectancies of you and your spouse. There's that to contend with.
The other thing that you have to contend with is you just have to recognize that when you're taking a pension stream of income in retirement, it is 100% exposed to tax rate risk because it's coming out of your tax-deferred bucket. What are the implications there? This is like the Social Security taxation, if you lose a much higher portion of your pension to taxation than you thought because tax rates rise dramatically over time to keep our country solvent, to keep us out of bankruptcy, then guess what's going to happen, you're going to have to find a way to compensate for all of that reduced amount of after-tax spending money that you receive. How do you do that? You're going to have to spend down all your other assets that much faster. If because of your pension your Social Security gets taxed and then you lose more of your pension than you thought to rising taxes, then that's a double whammy that's going to force you to spend down all your other assets that much faster. Now we're going from potentially spending our money down five to seven years faster, maybe we're spending our money down seven to ten years faster. Most of the time, when we double tax rates in all of our projections for our clients, you run out of money about twelve years faster than those that have already taken the pre-emptive measures to shift their money to tax-free. It's a big deal to have to account and compensate for all of this extra tax, whether it's a Social Security or to the federal government, that is just an unintended consequence of taking that stream of income out of your tax-deferred bucket.
What does a lump-sum distribution allow you to do? Again, I'm not saying you should do it, I'm just telling you the taxable implications and you should do the math for yourself before you decide you pull the trigger, but it allows you to take that lump-sum distribution and roll it into an IRA. Once it's in an IRA, then you can do all sorts of fun stuff with it. If you're younger than 59 1/2, you could do a 72t, I'm not necessarily saying you should do that either, but certainly, you could roll it into an IRA and you could do a Roth conversion, you could roll that money into the tax-free bucket. Then if you're really bent on having a stream of income that's guaranteed for life, you can roll that money into some sort of an annuity that gives you some sort of maybe, it's a deferred income annuity that lets the money build up over time and then somewhere down the road, you can pull the trigger and take income out of that. But guess what, now that income is going to come for the rest of your life or for the joint lives of you and your spouse in a tax-free environment where it's completely insulated from tax-rate risk, where you're not going to cause Social Security taxation. You can get your Social Security tax-free because that stream of income is now coming out of your tax-free bucket. This is something you don't read about all the time in the press, this is not something that's talked about a lot, but it's something that you should know about.
If you have a pension, and I find that about maybe 40% to 50% of the people we see day in and day out do have pensions, they're starting to go the way of the dodo bird, more people are having 401(k)s and 403(b)s these days because companies don't like to have the financial obligation of paying those pensions so we see more 401(k)s and 403(b)s, but if you're among the half of the people that we see day in and day out that do have a pension, you want to make sure that you explore whether you have a lump-sum distribution before you make a decision on taking a stream of income, because again, once you take that stream of income, once you elect to receive that benefit, whether it's over your lifetime or you and your spouse's lifetime, you have passed the point of no return, once you receive that first check and once you make that election, you cannot go back and say, “I changed my mind, I want to do the lump-sum distribution so that I can roll it into an IRA and then ultimately get into the tax-free bucket so that I can get to the 0% tax bracket and be insulated from the risk of higher taxes.” This is a big deal, folks, you have to be aware of what your options are before you get to that point in time where you're forced to make that election.
All right, I told you I'd keep it under 12 minutes, I honored my promise. Again, please subscribe so you can figure out what we'll be talking about each week and you'll get a little email in your inbox, a little alert, a little push notification telling you what we will be talking about. Again, if you need bulk discounts on our books, go to powerofzero.com/Books and if you want to subscribe to me on Twitter, please do so at @mcknightandco.
If you are looking for help in getting to the 0% tax bracket, we are happy to provide you some help, go to davidmcknight.com. If you’re an advisor and you want to learn how to incorporate these strategies into your practice so you can help your clients accomplish all these wonderful things, then you can go to powerofzero.com and opt in to our video series and it will lead you through a three video series that shows you how to incorporate these types of principles into your practice. Thanks, everybody for being on the podcast today and we will look forward to talking to you same time next week.