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Should I buy additional credit for my pension?

December 12, 2012: 6:30 AM ET

Should I purchase additional service credit to increase the final compensation for my pension plan? I'm currently 42 and plan to retire at 62. At that age, I will receive 81.5% of my $10,000-a-month income. I was told I could increase my final compensation by about 10% at the cost of $82,000 (which I plan to transfer from my 457 plan). Is this a good idea? – Name withheld

Given your age, the math works out in favor of leaving that money in your 457 plan, says Brent A. Marshall president of Senior Lifestyle Strategies, a financial advisory firm in Bullhead City, Ariz. "At 42, you have time on your side," he says. "You have to ask yourself what type of return you could earn over the next decades if you invested that money instead."

Crunching the numbers can help clear things up. For instance, withdrawing $82,000 from your 457 plan would likely be considered a taxable distribution. That means you'd have to pay taxes in addition to a 10% early distribution penalty you'd pay since you're younger than 59 ½. Assuming, for the sake of argument, that your withdrawal would put you in the 28% marginal tax bracket, you'd actually have to withdraw around $132,000 to cover the $82,000 pension credit. So you are essentially buying an extra $9,180 per year ($6,900 if it's fully taxable at a 25% rate) in pension income with $132,000.

Compare that to leaving the $132,000 invested in your 457 plan. In 20 years your principal would grow to approximately $263,000, assuming an annual return of 3.5%. If you rolled that into a traditional IRA at age 62 and continued to generate modest returns of 3.5% per year, you could withdraw roughly $13,000 each year until age 95. Wisely managed, that money could generate returns closer to 5.5%, according to Marshall, which would enable you to withdraw closer to $16,500 per year until age 95. After taxes, that would translate to just over $12,000 per year, assuming a 25% marginal tax rate — close to $5,000 more than what your pension credit buys you.

Keep in mind that the extra growth offered by the IRA comes with a tradeoff: Your retirement account can lose value if the markets drop, whereas a pension provides guaranteed, protected income. On the other hand, that guarantee might be more expensive than you realized.

— Marc Mewshaw

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