Lump Sum or Lifetime Income: The Dilemma of Inherited IRAs

In the world of personal finance, few decisions are as consequential as what to do with an inherited IRA. A couple with $1.5 million and two inherited IRAs recently posed a question on Reddit: "Is it crazy to take a lump sum and invest it somewhere with a slightly higher yield?" This query underscores a broader dilemma faced by many retirees and pre-retirees: should they opt for the security of a lifetime income stream or the potential for higher returns through lump-sum investments?



The Case for Taking a Lump Sum

Taking a lump sum from an inherited IRA and investing it in higher-yielding assets can be an attractive option for several reasons. Firstly, the potential for higher returns is a significant draw. If the couple invests in assets that yield 5.9% annually, they could potentially generate more income than the guaranteed annuity payments from the pension. This is particularly relevant in the current economic environment, where the 10-year Treasury bond yields have flattened out after declining more than 0.50% earlier this year. The yields remain above last year’s lows, with a narrow range between 4.16% and 4.34%. This suggests that investing in bonds or other fixed-income securities might not yield high returns, making other investment options more attractive.

Secondly, taking a lump sum provides greater flexibility and control over investments. The couple can choose to invest more aggressively if they are comfortable with the added risk, potentially leading to higher returns. This flexibility is a significant advantage, especially for those who are confident in their investment acumen.

Thirdly, rolling over the lump sum into a Roth IRA can offer tax-free withdrawals in the future. This is a substantial benefit, as withdrawals from a Roth IRA are tax- and penalty-free as long as the account has been open for at least five years and the account holder is age 59½ or older. This tax advantage can be a game-changer for retirees looking to maximize their income in retirement.

The Risks of Taking a Lump Sum

However, taking a lump sum from an inherited IRA is not without its risks. Market fluctuations are a significant concern. The value of investments can decrease, reducing the overall value of the lump sum. This risk is particularly relevant in the current economic environment, where market volatility can affect investment returns. The Federal Open Market Committee (FOMC) chose to maintain the short-term federal funds target rate in a range of 4.25% to 4.50% in March 2025, and markets do not anticipate another Fed rate cut before June 2025. This stability in short-term rates can provide a sense of security for investors considering a lump sum payout. However, the Fed's decision to trim its reduction of U.S. Treasury security holdings from $25 billion to $5 billion per month starting in April 2025 indicates a shift in monetary policy that could affect market liquidity and volatility.

Another risk is the responsibility for investing. The couple will be responsible for making investment decisions, which can be a significant burden if they are not comfortable with managing investments. This responsibility is a double-edged sword, as it provides greater control but also comes with the risk of making poor investment decisions.

Additionally, taking a lump sum from an inherited IRA will result in immediate tax liabilities. The couple will have to pay income tax on the money just as they would with any other Roth IRA contribution. This tax implication is a significant consideration, as it can reduce the overall value of the lump sum.

The Case for Lifetime Income

On the other hand, opting for a lifetime income stream through a pension plan has its own set of advantages. Pension plans typically provide the payment of a set amount every month from retirement date for the rest of the retiree's life. This provides a steady and predictable income stream, which can be particularly valuable for retirees who are risk-averse or who have limited investment experience.

Moreover, pension plans often come with inflation protection, which can help retirees maintain their purchasing power over time. This is a significant advantage, as inflation can erode the value of fixed-income investments over time. In the current economic environment, where consumers anticipate inflation jumping to 4.9% over the coming year, inflation protection can be a valuable feature of a pension plan.

However, pension plans also have their drawbacks. The monthly payments are typically not adjusted for inflation, which can reduce their purchasing power over time. Additionally, the ability to collect pension payments depends on the company's ability to make them. If the company retains the pension and can't make the payments, a federal agency called the Pension Benefit Guaranty Corporation (PBGC) will pay a portion of them up to a legally defined limit. This provides some protection, but it is not a guarantee of the full pension benefit.

Conclusion

The decision to take a lump sum from an inherited IRA and invest it in higher-yielding assets is a complex one, with both potential benefits and risks. The potential for higher returns and greater control over investments are significant advantages, but the risks of market fluctuations, the responsibility for investing, and the lack of guarantees must also be weighed. Additionally, the immediate tax implications of taking a lump sum should be factored into the decision.

In the current economic environment, characterized by stable but slightly higher interest rates, moderate market volatility, and expectations of higher inflation, taking a lump sum from an inherited IRA and investing it in growth-oriented assets could be a strategic move. However, investors should carefully consider their risk tolerance and investment goals before making such a decision. It is also advisable to seek advice from a financial professional to make an informed decision based on their current financial situation and long-term goals.