Lump sum Distribution
Lump sum distribution as you move into retirement can be a tricky and complex path to navigate. Even the hardiest of accountants have cause to pause when tackling this topic. The tax implications can be complicated but if you are looking to cash out of your company's qualified retirement plan then you need to do your homework. Most workers especially those born post 1935 should consider rolling over their retirement accounts into an IRA. This permits continued to deferral of taxes and when you decide you need the money all you need to do is follow the IRA withdrawals rules.
For those employees who want to receive a lump sum distribution they will be required to pay the taxes straight away. If you were born prior to 1936 there are several options for reducing taxes as opposed to a single option available to everybody else.The rules are complex. But stick with us through the definitions, and you'll learn what you need to know.
What Is a Lump Sum Distribution?
Let us assume you are receiving a lump sum distribution as defined by the tax law. This can be through several payments provided they are all made in the same year. A lump-sum distribution can be that of employer stock, stock bonus plan or employee stock ownership plan.Being born pre 1936 means lump-sum distributions are eligible for more lenient taxation than your everyday retirement account withdrawals. Understand, you only have a lump sum distribution if you are in receipt of your complete account balance in the same year from your employer’s pension plan, profit sharing plans, including your 401k and stock bonus plans ALL maintained by the same employer.
If your employer has several different plans, you will receive a lump sum distribution if you cash out of all those plans in the same year. However if you receive as an example your pension money one year and your 401k the next, you would in fact have two lump sum distributions in taxable from both years. Obviously this is not a good thing so try your utmost to do everything e in the same year. The favorable lump-sum distribution tax rules can only be utilized in one year or the other.IRA or SEP withdrawals cannot be a lump sum distribution and as such will not qualify for the special tax breaks I am about to share with you. Neither can withdrawals from Section 457 deferred compensation plans for state and local government employees and Section 403(b) tax sheltered annuity plans.
Further, if you are self-employed you cannot liquidate your retirement account as a lump sum distribution with two exeptions
You are over 59 1/2 years old or have become permanently disabled.If you had an employer you must receive the money due to one of the following You were fired, quit, or became disabled or died You reached 59 1/2, in which case you can continue to work if you so choose and still get your withdrawals as a lump sum distribution.
You can have a lump-sum distribution if you meet the requirements above however under the guidelines explained above, but the more favorable options still will not be available to you unless
You were born before 1936,
You participated in the plan for at least five years (this rule is waived if you die),
You pay tax on the entire amount received (in other words, no tax free rollovers of any part of your money into an IRA and
You have not previously used the special tax rules explained later for any post-1986 lump-sum distributions.
If Your Distribution Doesn't Qualify
Let's say your withdrawals fail to qualify as a lump-sum distribution in the first place, or they meet the lump sum definition, but you fail any of the four tests immediately above. Now you must simply treat the entire amount as ordinary income and pay tax at your regular rate. That may not be what you wanted to hear, but at least it's simple. Watch out, however. You may also owe the 10% penalty tax on premature retirement account withdrawals. The penalty is over and above the regular income tax hit, and it applies unless:
• you are age 59 1/2, disabled, dead, or
• you are 55 and retired, quit, were terminated, or
• you take the money in annuity-like payments over your life expectancy, or
• the money goes for medical bills in excess of 7.5% of your adjusted gross income (AGI) or
• the money is going to your spouse or ex-spouse in a divorce or separation under a qualified domestic-relations order (in which case that person will owe the resulting income tax but no 10% penalty).
For qualified retirement plan withdrawals, these are the only exceptions to the 10% penalty (there are some additional exceptions for IRA withdrawals, but they do you no good in this context). So at this point, you may want to reconsider the IRA rollover option. If not, please keep reading.
If You Were Born After 1935
Assuming you met all the ground rules, you were (note the past tense) allowed to compute the tax on your lump-sum distribution as if the income were spread evenly over five years — this was the so-called five-year averaging privilege. Unfortunately, five year averaging became history as of the end of 1999.
These days, you must simply include your lump-sum distribution as ordinary income on page 1 of Form 1040 (on the line for pensions and annuities). The tax bite will be much more acceptable if your overall taxable income would otherwise be negative
due to personal exemptions, itemized deductions, alimony payments, capital losses, business losses, deductible passive losses, etc. These deductions and losses can offset your income from the lump-sum distribution and may result in a surprisingly low overall tax bill. But this favorable scenario is not very likely. The usual outcome is that the lump-sum distribution gets piled on top of all your other income. This may push you into higher tax brackets. Plus, the additional income may increase your AGI to the point where the personal exemption and itemized deduction phase out rules kick in. You may also lose other AGI sensitive tax breaks. Once again, you may want to consider rolling over your lump-sum into an IRA.
If You Were Born Before 1936
Here is where the good news starts. Taxpayers in this age bracket have several options:
• You can report all or part of the lump sum distribution as ordinary income on page 1 of your 1040. Generally, this is not the best choice for the reasons already mentioned.
• You can use 10-year averaging for all or part of the lump sum distribution using the 1986 tax rates for single taxpayers.
• For the part of your distribution attributable to pre-1974 plan participation (if any), you can pay a 20% capital gains tax and use either of the preceding methods for the balance. If you have pre-1974 participation, the amount eligible for the 20% tax should be included on the Form 1099-R received from the plan administrator. (Note: The 20% rate on capital gains from lump-sum distributions was not reduced by the 2003 tax legislation.)
For the second and third options listed above, you make your choice and the resulting tax calculations on Form 4972 (Tax on Lump Sum Distributions from Qualified Retirement Plans.
This is a key point: Your AGI does not include amounts for which you pay the 20% capital gains tax or amounts for which you use 10-year averaging. So AGI-sensitive tax breaks are not adversely affected by the income from the lump-sum distribution, if you choose either of these methods.
Choosing the right option will require some shrewd calculations on your part. You should consider hiring a tax professional if the figures are substantial. This is one situation is where doing it yourself is not the way to save money and could end up losing you a bucket load.
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