I recently learned that I received a pension of $54,845 from a friend. I had a choice as to how I wanted to receive the money: a lump sum, an extension, or deferring payments over a certain number of years. I have nothing saved for retirement and don’t know what to do. What is the best option and how can I avoid paying a lot of taxes?
–Shannon
I’m sorry to hear of your friend’s death, Shannon. As with any question and answer asked in such a context, I can’t tell you specifically what you should do. But I can help you frame your situation so that you better understand what is going on and what options you have. Hopefully this will help you decide what is best for you. (And if you have a specific financial planning question like this, you should consider speaking directly to a financial advisor.)
Inherit a pension
The two big variables that determine the tax treatment of an inherited annuity are whether or not you are the spouse of the annuitant, and whether the annuity was qualified or non-qualified.
Based on your question, I am assuming that you are a non-spousal beneficiary of a qualified annuity. This means that the pension is held in some type of retirement account such as a 401(k) or IRA account. If my assumption is correct, you will owe income tax at your personal tax rate when you withdraw funds from the account. This is important to understand because it influences which option you should choose. (And if you want to know how your decision about an inherited annuity affects your overall financial or retirement planning, consider working with a financial advisor.)
Options for dealing with your inherited pension
If you actually inherited a qualified annuity, the decision to receive payments, take the entire amount as a lump sum distribution, or convert it to an inherited IRA has specific tax implications. You have to remember that the money is taxable when you withdraw it. If you elect to receive payments, each payment will be included in your taxable income as soon as you receive it.
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If you take the entire amount as a lump sum, keep in mind that you will have to include the entire remaining amount in your taxable income in the year in which the distribution is made.
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If you convert it to an inherited IRA, the distribution rules for inherited IRAs apply. You’ll likely need to withdraw the entire balance within 10 years. Instead of being taxed on the full amount immediately, each distribution is taxable in the year you receive it.
In general, from a tax perspective, it is better to spread distributions over a longer period of time rather than taking a lump sum. However, this is not always the best way. It depends on the tax bracket you are currently in and what tax brackets you expect to have in the future. The idea is to make your distributions when they are subject to the lowest possible tax rate. (And if you would like further advice on your tax strategy, consider speaking to a financial advisor.)
Consider your goals
While tax minimization should certainly factor into your decision, it may not be the most important factor. When deciding what to do, consider your own situation and goals and choose the option that will make the most effective use of your legacy. This could be a combination of tax efficiency and something else like cash flow management.
For example, you may have debt that you need to get rid of or you may need urgent repairs to your home. If you’re using retirement to achieve any of these goals that will help you get ahead or escape financial stress, then it’s worth considering.
Next Steps
Assuming you have a qualified pension, you will have to pay taxes when you withdraw money. Depending on your overall situation and other goals, you may want to spread your distribution out over several years or take a lump sum. There is no one best answer that applies to everyone.
Tips for Finding a Financial Advisor
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Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three verified financial advisors working in your region, and you can have a free discovery call with your matching advisors to decide which one you think is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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Consider a few advisors before choosing one. It is important that you find someone you trust to manage your money. As you weigh your options, consider asking an advisor these questions to ensure you are making the right choice.
Brandon Renfro, CFP®, is a financial planning columnist at SmartAsset, answering reader questions about personal finance and tax topics. Do you have a question you would like answered? Email [email protected] and your question may be answered in a future column.
Please note that Brandon is not a participant in the SmartAdvisor Match platform and has received compensation for this article.
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