Pension Buyout to IRA: Roll Over or Take the Annuity?

The decision, resolved with numbers

Robert is 62, single, and lives in Georgia. His former employer’s pension plan has sent him a one-time buyout offer: take a $600,000 lump sum now, or take a single-life annuity of $3,100 per month ($37,200 per year) starting at 65. He has a 401(k) elsewhere and does not need the pension cash to cover his bills. The question he keeps asking: “If I take the $600,000, do I owe tax on it?”

The answer is the whole game. If Robert takes the $600,000 as a check made out to him, the plan must withhold $120,000 and he risks taxing the rest. If he takes the same $600,000 as a direct, trustee-to-trustee rollover into a traditional IRA, he owes $0 in tax and $0 in withholding — the full $600,000 lands in the IRA. Same lump sum, two completely different tax outcomes, and the difference is one box on a form.

So the real choice is not “lump sum or annuity.” It is: rolled-over IRA (control, upside, legacy) versus monthly annuity (guaranteed income you cannot outlive, zero management). Below is the rule, the trap, the RMD fallout, and how Robert decides.

Why a direct rollover is tax-free: IRC §402(c)

A pension lump sum is an “eligible rollover distribution” under IRC §402(c). The code lets you move it into another qualified retirement vehicle — a traditional IRA is the usual destination — without recognizing any income, as long as the transfer is done correctly. There is no dollar cap on a rollover. Robert’s entire $600,000 can move tax-free.

The catch is the word directly. There are two ways to roll money, and only one is safe:

• Direct rollover (trustee-to-trustee). The pension plan sends the money straight to your IRA custodian. The check is made payable to the custodian “for benefit of” (FBO) you — not to you personally. No withholding. No tax. The plan reports it on Form 1099-R with distribution code “G”, which tells the IRS it was a direct rollover. This is what Robert should do.
• Indirect rollover (60-day rollover). The plan pays the money to you, and you have 60 days to redeposit it into an IRA. This is where the trap lives.

The 20% withholding trap: IRC §3405

Here is the part that costs people real money. Under IRC §3405(c), when an eligible rollover distribution is paid to you instead of sent directly to the IRA, the plan is required to withhold 20% for federal income tax. This is not optional and you cannot waive it.

On Robert’s $600,000, that is $120,000 withheld. He receives a check for $480,000. To complete a tax-free rollover, he must deposit the full $600,000 into an IRA within 60 days — which means he has to come up with the missing $120,000 from his own savings to make the IRA whole. He gets the $120,000 back only when he files his tax return the following spring as a refunded overpayment, assuming he had no other tax due.

If Robert cannot replace the $120,000, then that portion is treated as a distribution he kept. It becomes taxable income, and because he is 62 (over 59½) he avoids the 10% early-withdrawal penalty — but a younger retiree under 59½ would owe that penalty too. A direct rollover sidesteps the entire mess: no check to you, no 20%, nothing to replace.

What a straight cash-out actually costs

Suppose Robert ignored the rollover entirely and just kept the $600,000. For a single filer, that distribution stacks on top of his other income and runs up the 2026 federal brackets fast. The 35% bracket for a single filer covers $250,526 to $626,350 of taxable income, so the bulk of a $600,000 distribution is taxed at 32% and 35%. A back-of-envelope federal bill on $600,000 of ordinary income alone is well over $170,000 — before Georgia’s flat 5.39% state income tax adds roughly another $32,000.

That is the cost of doing it wrong: more than $200,000 in combined tax to convert a tax-deferred pension into spendable cash he did not even need. The direct rollover preserves all $600,000 and defers every dollar of that tax until he chooses to withdraw — on his schedule, in lower-income years, in controllable slices.

The catch on the IRA side: RMDs at 73 or 75

Rolling to an IRA is not tax-free forever — it is tax-deferred. Once the $600,000 sits in a traditional IRA, it becomes subject to required minimum distributions under SECURE 2.0 §107. Your birth year sets the start age:

Robert was born in 1963, so his RMDs start at 75. The IRS Uniform Lifetime Table (Pub. 590-B, Table III) sets the divisor by age: at 73 it is 26.5 (about 3.77% of the prior year-end balance), and at 75 — Robert’s actual first-RMD age — it is 24.6 (about 4.07%). If the rolled $600,000 were sitting in the IRA at that first RMD, his age-75 forced withdrawal would be about $24,390 that year ($600,000 ÷ 24.6), all taxable as ordinary income, and the required percentage climbs each year after.

Miss an RMD and the penalty is 25% of the shortfall (reduced from the old 50% by SECURE 2.0), dropping to 10% if you fix it inside the correction window. The annuity, by contrast, has no RMD — it is already paying you a stream the IRS deems sufficient. If forced withdrawals and the surrounding tax planning sound like a chore you do not want, that is a genuine point in the annuity’s favor.

Control and legacy: the IRA’s real edge

The headline reason to roll rather than annuitize is what happens to the money in two scenarios: while you are alive, and after you die.

• While alive — control. A $600,000 IRA is yours to invest, spend in lumps for a roof or a wedding, draw down faster in low-income years to smooth your lifetime tax, or leave untouched to compound. The annuity gives you a fixed $3,100 a month and nothing else — you cannot accelerate it, borrow against it, or change the amount.
• At death — legacy. Any balance in the IRA passes to your named beneficiaries. A single-life pension annuity typically pays $0 the day you die — if Robert takes the $3,100 single-life annuity and dies at 68, the remaining value is gone. A joint-and-survivor annuity keeps paying a spouse but at a reduced monthly amount, and still leaves nothing to children. The IRA leaves the full remaining balance to heirs.

Non-spouse heirs of a traditional IRA generally must drain it within 10 years of your death under the SECURE Act 10-year rule (IRC §401(a)(9)(H)); a surviving spouse can roll it into their own IRA and treat it as theirs. Either way, the money survives you — which a single-life annuity does not.

When the annuity actually wins

The IRA is not automatically better. Annuitizing is the stronger choice when:

1. You want a paycheck you cannot outlive. The annuity is longevity insurance — if Robert lives to 95, the $3,100 keeps coming regardless of how markets behaved. An IRA can be exhausted by a bad sequence of returns plus overspending.
2. You do not want to manage money. No investment decisions, no rebalancing, no RMD calculations, no sequence-of-returns risk. For someone who would otherwise leave the cash in a checking account earning nothing, the annuity’s discipline is worth a lot.
3. The annuity’s payout rate beats what the cash can safely earn. Robert’s offer is $37,200/year on a $600,000 lump sum — a 6.2% payout rate. That is the lens: compare the annuity’s implied rate to what $600,000 could safely generate on its own, factoring in your health and family longevity. The companion post on the discount-rate decision walks through that comparison.

What most people get wrong

The single most common, most expensive mistake is the “I’ll just deposit it myself” misunderstanding. People assume that because they intend to roll the money into an IRA, taking the check first is harmless — they’ll just move it over next week. It is not harmless. The instant the plan cuts a check to you personally, §3405 forces the 20% withholding, and now you must front $120,000 of your own cash within 60 days to complete a full rollover. Miss the 60-day window and the whole thing becomes a taxable distribution.

Three more myths worth correcting:

• “Rolling to an IRA is a taxable event.” A direct rollover to a traditional IRA is not taxable — it is reported on Form 1099-R with code “G” and adds nothing to taxable income. Rolling to a Roth IRA is different: that is a conversion, and the full $600,000 would be taxable in the conversion year. If tax-free is the goal, the destination is a traditional IRA.
• “The annuity is safer because it’s guaranteed.” The guarantee is only as strong as the plan or insurer behind it. Private pensions are backstopped by the PBGC up to federal limits; an insurance-company annuity is backed by state guaranty associations up to a cap. “Guaranteed” does not mean “unlimited and risk-free.”
• “The lump sum lets me avoid RMDs.” The opposite. The annuity has no separate RMD; the rolled IRA creates them at 73 or 75. Choosing the lump sum is choosing to manage RMDs later — a fair trade for control, but not an escape from forced withdrawals.

How Robert should execute — the steps that matter

1. Open the receiving traditional IRA first. The account must exist before the pension cuts the check, so the funds have somewhere to land.
2. Instruct the plan: direct rollover, check payable to the custodian FBO Robert. Not to Robert personally. This is the box that turns off the 20% withholding.
3. Confirm the 1099-R shows code “G.” Code G signals a direct rollover and tells the IRS no tax is due. If it shows a taxable code instead, fix it with the plan immediately.
4. Never have the check mailed to his home. A check in his hands, even briefly, is an indirect rollover with all the withholding consequences.
5. Plan the future withdrawal map. With $600,000 deferred in the IRA, model RMDs starting at 75 and consider partial Roth conversions in his low-income early-retirement years to thin the future RMD base.

The decision lever

If you want control of the money and a balance your heirs inherit, take the lump sum — but only as a direct, trustee-to-trustee rollover to a traditional IRA, so the full $600,000 moves with $0 tax and $0 withholding, and accept that RMDs begin at 73 or 75. If you want a guaranteed monthly check you cannot outlive and zero money management, take the annuity — and weigh its 6.2% implied payout rate against what the cash could safely earn on its own. The one outcome to avoid at all costs is the check made out to you: that single misstep triggers the mandatory 20% withholding under §3405 and can turn a tax-free rollover into a six-figure tax bill.