What is a pension plan, and how does it work?

As mentioned above, a pension plan is a retirement fund that your employer regularly contributes to. When you retire, the pension provides you with regular payments — your retirement income.

The Employee Benefits Security Administration of the Department of Labor, which administers and enforces the Employee Retirement Income Security Act (ERISA), regulates most private-sector pension plans.

There are two main types of pensions:

  • Defined benefit pension: A defined benefit plan promises to pay you a certain amount after retirement, like an insurance policy. Sometimes called a “final salary” or “career average pension,” this type of plan guarantees you an annual fixed amount set by the terms of your plan.
  • Defined contribution pension: Also known as a “money purchase” pension or a “pension pot,” a defined contribution plan pays you a lump sum upon retirement. The size of the lump sum is determined partly by how much your employer has contributed to the pension.

Which plan is best for you?

Let’s take a look at a common dilemma faced by many employees nearing retirement when it comes to choosing their pension.

Pension options from a defined benefit plan generally include a lifetime payment with no survivor benefit, a joint and 50% survivor payment, or a joint and 100% survivor payment. The joint and survivor benefits are reduced amounts from the lifetime payment option.

If you were to select the lifetime payment and then pass away before your surviving spouse, you would leave no monthly pension for your spouse. On the other hand, if you select one of the survivor options and your spouse passes away before you do, you will be locked into the lower payout for the rest of your life. This amount of potential loss of income can be devastating, either for you or your spouse.

Emotionally, you may be inclined to choose one of the pension options that offer an ongoing benefit to your surviving spouse in the event of your death.

However, there may be better financial decisions and other actions you can take as part of your pension planning to help offset any potential income loss. For example…

Insuring the Pension

Suppose you are an employee in good health. In that case, you could consider purchasing a life insurance policy that will provide a death benefit to your spouse if you pass away and leave your spouse without a continuing pension payout.

Your spouse can then use the death benefit from the insurance policy to create an ongoing income by purchasing an immediate annuity. This income could replace all or some of the amount lost from the pension, thereby allowing you to select the lifetime payout option.

If you decide to go with the lifetime payout in combination with a life insurance policy, the lifetime payout from the pension will cease in the event of your death. Then the beneficiary will receive the life insurance free of income tax. Your spouse could use the life insurance payout to purchase an immediate annuity and generate lifetime income.

On the other hand, if your spouse were to pass away first, you would have several options. First, the lifetime payout would continue at the full amount for you, and you could continue the life insurance for other beneficiaries, such as children. Alternatively, you could modify your policy to provide a reduced paid-up insurance amount or terminate the policy entirely and receive any cash value return.

There are, however, some tax consequences you should take into consideration.

Tax Consequences

You, as a retired employee, or your surviving spouse in the event of your death, will generally be taxed on the pension amount at the time of payment. On the other hand, as mentioned, a payout from a life insurance policy is free of income tax for the beneficiary. Meanwhile, annuity payouts, such as from an annuity purchased from the death benefits, is paid to the surviving spouse as part interest and part return of principal.

Depending on the age of the person taking the annuity, the interest rate, and the guaranteed period of time the annuity will pay out, most of the annuity payment will be a return of principal. You can determine the taxable income from the annuity payments by calculating the exclusion ratio of how much of each payment is return of principal and how much is interest.

If, as a retired employee, you change a life insurance policy to a reduced paid-up amount, you will have no tax consequences: the death benefit will still be income-tax-free when it is paid out to your beneficiaries. For a policy that is terminated and cashed in, the amount received more significant than the amount of premiums paid into a policy would be taxable income.

There are some risks to this approach, such as…

Possible Risks

Life insurance policies generally have an incontestability clause. The terms of this type of clause can vary from state to state but can allow the insurance company to dispute the death benefits. Additionally, if you, as an employee, are not in good health, and a life insurance policy would have a higher premium, it may not be financially beneficial to purchase an insurance policy.

Many life insurance policies lapse or end at age 100 with no cash value. This helps keep premiums down, but it can be a big problem if you live past age 100 — in that case, your insurance will have been entirely cost and no benefit. Universal life insurance policies can offer a guaranteed provision; however, premiums will be more expensive for these policies.

There are other risks and possible drawbacks, as well. For example, the entire pension amount is taxable, and the life insurance premium is not tax deductible.

In closing…

As you will have learned herein, your decision regarding your pension plan can significantly impact your future retirement income. Before making your choice, you must explore all options — and start planning as soon as possible.

A comfortable and well-funded retirement free of financial stress is possible. All it takes is some careful, well-informed pension income planning, and you can build and secure the future you deserve.

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