By Matthew Sivertsen, CFP® and Cicily Maton, CFP®
As financial planners, we are consistently faced with helping people understand various concepts related to money. One concept that comes up time and time again is whether to take a lump sum of money, or choose instead a series of payments in the future.
Admittedly, having to decide how to receive a windfall in any form is a great problem to have. The key to helping our clients decide which option might be best for them is to have a really good handle on every component of their finances. It also helps to understand their general sentiments about, and behavior profile around, money.
The first step is to review our clients’ cash flow and expenses. Do they have too much or too little monthly income? How well do they manage it? The second step is to evaluate their balance sheet and calculate the value of their assets minus their liabilities. Do they have strong or weak asset positions? Are their debts manageable? The third step is to look at the big picture and take into account other factors like familial considerations. Do they have loved ones who are dependent on this plan? Are there estate objectives dedicated to their children or others?
Here are two case studies demonstrating how complicated choosing the best method of payment can be.
Example 1: A couple in their 60’s, both employed by government agencies, has assets of $1,000,000 in an IRA, plus a home they own. An analysis by an advisor determines that they would be better off financially, by a very small margin, with taking a lump sum payment. There was risk involved since the stability of the state government agency to be able to maintain a payments over time, without some financial adjustment, was very problematic. Nonetheless, their decision was to take the future payments, fully aware of the risk that if payments from the government were cut in the future they would have the IRA to rely on for their welfare.
Example 2: A couple, both 65 and employed at different corporations, held assets of $600,000 plus two homes, one of which was about to be sold. Their decision was to take the lump sum, as the couple had little confidence that the corporations would not adjust payouts in the future if economic conditions took a turn for the worse. They were comfortable with their decision even though a financial analysis indicated that the payments over time would be somewhat more advantageous.
Obviously there are pros and cons with either method of payment chosen. While some factors are related to market conditions, other financial or personal issues might come into play. Here are just a few of the factors an advisor must consider in helping clients make informed decisions.
Pros of Lump Sum Payments
- You maintain control of the money, with the freedom to invest in a financial portfolio that is tailored to your personal circumstances.
- It is an asset on your balance sheet and you have control over how to distribute the money upon your death.
- You do not have to worry about the stability of the underlying company/government agency/insurance company, etc., to pay out obligations over a long period of time.
- If proceeds are invested in a portfolio, growth may be taxed at lower capital gain rates.
Cons of Lump Sum Payments
- You assume market risk.
- If you take on too much risk, the market could experience a downturn in the early years of retirement, jeopardizing the ability of your portfolio to maintain its value over the long term and increasing the possibility you will run out of money.
- If investments are too conservative, returns may not be high enough to generate the money needed to sustain your standard of living.
- There may be the tendency for you to overspend, drawing out more money than the portfolio can generate over time.
Pros of Payments over Time
- There is the discipline of stable periodic payments, helping you to control overspending.
- There are no worries about investment decisions.
- You have an ability to use other assets to meet specific goals.
Cons of Payments over Time
- You have no control of investments.
- There is the risk of the underlying company/government agency/insurance company becoming unable to meet their obligations or changing policy affecting payout benefits.
- You have a limited choice of beneficiaries.
- You have a limited or no opportunity to get additional money in an emergency.
- Your distributions are taxed at ordinary income tax rates, which may rise higher.
As you can see, if you are fortunate enough to receive a windfall, deciding whether to take a lump sum or receiving a future series of payments is not an easy decision. It requires careful consideration of your life goals and objectives. Your money management habits—good or bad—may also factor into the decision that is ultimately made. At the end of the day, your financial advisor can provide you with the guidance you need to decide what’s in your best long-term interest. If you are facing a difficult decision, just give us a call. Let’s have the conversations that matter.
Matthew Sivertsen, CFP®, CeFT™, is a Partner/Sr. Financial Planner in the Quad Cities office of The Planning Center, a fee-only financial planning and wealth management firm. Email him at firstname.lastname@example.org.
Cicily Maton, CFP® is a Partner/Sr. Financial Planner in the Chicago office of The Planning Center, a fee-only financial planning and wealth management firm. Please email her at: email@example.com.