Lump-Sum Distributions and Taxes

If you’re currently receiving distributions from a retirement plan like a 401(k), one of your main considerations is dealing with taxes due on the money. Some people choose to roll over the account to another tax-deferred plan, but it some cases it is better to pay current taxes with a lump-sum distribution. The advantage to withdrawing your money this way is that you can invest the funds any way you wish. For some individuals, a good investment strategy may make up for the money lost through taxes. For others, it will be a costly mistake.

If you choose to take a lump-sum distribution from your account, taxes will be due on the total amount of the distribution and must be paid during that same year. Since your employer is required to apply 20 percent of the check to federal taxes, you’ll actually only receive 80 percent of your funds.

Obviously, parting with 20 percent of your funds is a huge disadvantage. Income taxes on the distribution are calculated based on your marginal income tax rate. Taking a large distribution could potentially move you into a higher tax bracket, and therefore your tax rate would be higher for the year. Also, if you take the distribution before age 59 ½, it is subject to an addition tax penalty of 10 percent.

If you were born prior to 1936, you participated in the retirement plan for at least five years, and you’ll be receiving a total distribution of your retirement account, you can take advantage of two different options to lower your tax burden.

The first option, called 10-year averaging, allows you to treat the distribution as if it was received in 10 equal annual installments. Each year you can calculate your taxes due based on the 1986 tax tables for a single filer.

The second option, capital gains tax treatment, allows you to have a portion of your distribution taxed at a flat rate of 20 percent. This only applies to the portion of your account which accumulated prior to 1974. Obviously, this is helpful if your tax rate would have been higher than 20 percent. The rest of your distribution may be taxed according to 10-year averaging, if you qualify for that option as well.

Since taking a lump-sum distribution can be costly, and involves many complicated tax decisions, consulting with your tax advisor is imperative before making this decision.

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The views presented are not intended to be relied on as a forecast, research or investment advice and are the opinions of the sources cited and are subject to change based on subsequent developments. They are not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investments.