The “lump-sum option”—also called the “alternative form of annuity” – remains one of the most misunderstood aspects of federal retirement policy. Many employees approaching retirement continue to ask for it even though it no longer is generally available.
The lump-sum option was created as a replacement for the old “three-year recovery rule.” That was the policy in which those retiring didn’t have to pay taxes on their annuity payments for up to three years while they got back an amount equal to their contributions into the federal retirement fund—money that had already been taxed. As a practical matter, the tax-free period lasted about half that long for most retirees.
Under the original lump-sum option, retirees were allowed to take out at retirement an amount deemed equal to their contributions, while accepting an actuarial reduction in their annuity based on the average life expectancy for someone of that age. The option was widely available—and widely popular—after its creation in 1986. But it drew a great deal of attention from keepers of the federal purse strings and was eliminated effective October 1, 1994 for everyone except those suffering from a medical condition that is expected to be fatal within two years.
Those with life-threatening conditions still may elect the lump-sum and have their annuity actuarially reduced the same life expectancy formula, even though by definition anyone now eligible for this option has a much shorter life expectancy. The Office of Personnel Management has a list on its site of medical conditions that are automatically qualifying for the alternative form of annuity, when supported by medical documentation. Other conditions are considered on a case by case basis.
Even though it’s been many years since that change, many employees approaching retirement still seem to be making plans based on having a lump-sum available to them. In many cases that may be because they came into government around the time of the original lump-sum design and apparently still have that concept of it.
Those who need a lump-sum at retirement for a certain purpose—such as paying off a mortgage or other loans or making a major purchase—might instead consider a Thrift Savings Plan lump-sum withdrawal.