Your Guide for Understanding Pension Plans

Do you have a pension plan or are thinking about contributing to one? If so, it’s important to understand how they work. Many people are unaware they can’t take an early withdrawal. Keep reading to learn how pension plans work.

What Is a Pension Plan?

A pension plan is a form of retirement fund that your employer maintains. Once you retire, the employer gives you a payout of your choice. Pension plans are a type of defined benefit plan. The amount of the payout you receive once you retire depends on your salary as well as how long you worked for that specific employer. You have the option to take a lump-sum payout or monthly payments, also known as annuity payments.

What Happens If I Leave the Company Before Retirement?

It’s important to understand that pension accounts are not portable. The length of time you worked for an employer significantly impacts how much you’ll earn through pension payments once you retire. If you switch companies, you’ll need to contact your old employer with which you had a pension account with and apply for your benefit.

Is a Lump Sum Payout Better Than Monthly Payments?

Your preferences and financial needs will determine whether a lump-sum payment or monthly annuity payments are best. The majority of people choose monthly payments. They enjoy having a steady income, and this is particularly beneficial for those who aren’t experienced investors. A lump-sum payout means you must be extremely self-disciplined with the ability to stick to a budget. Getting a lump-sum payout may make you think you have a lot of money to lean on and, therefore, you spend it quickly. With monthly payments, the temptation to spend all of the money in a short amount of time is removed.

Is it Possible to Borrow Against a Pension Plan?

Many people will dip into their 401(k) or individual retirement account plans before they retire. Doing this usually means a penalty has to be paid. This setup often makes people think they can tap into their pension funds before they retire as long as they pay a penalty. This is a false assumption as it is not possible to take out a loan against a pension plan.

Are Pension Payouts Subject to Taxes?

You will have to pay taxes on your pension. In most cases, you will include the entire amount that you receive from your pension on your tax return for the year that you received the funds. If you choose a lump-sum payout, the taxes owed will be much larger than what you will owe if you choose monthly payments. Why? Because you only pay taxes on what you are paid for that given tax year.

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There are exceptions to paying taxes on pension payments. If you contributed to your pension on an after-tax basis, you aren’t responsible for paying taxes on the portion of the payment that reflects the after-tax funds being distributed back to you.

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