When you retire, you may be offered a chance to take your retirement benefits in a lump-sum. Temper your excitement about the prospect of getting a big hunk of cash with the thought of the huge tax bill it will trigger. The tax law gives you several options on how to handle such a payout, and the choice you make can have a lot to do with how financially comfortable you are in retirement.
When you receive a lump-sum payment, the first thing you should do is subtract from the distribution any after-tax contributions that you made to the plan. That's your money, and it's tax-free. As for the taxable part:
Beware: Special withholding rules must be taken into account as you consider how to handle a payout from your company retirement plan. If the money does not go directly from the company to an IRA—or your new employer's plan—20% of it will be withheld for the IRS.
Congress has greatly simplified the rules for rollovers and expanded employees' right to roll over retirement money from one employer's plan to another's if the new employer's plan allows such rollovers. For example, the law now allows transfers from a 403(b) plan or 457 plan to a 401(k), something that has been banned in the past. Also, rollovers can now include after-tax contributions which, in the past, could not be rolled over. (Any after-tax money in a plan had to be withdrawn, tax-free, of course.) Again, it is up to the new employer rather to allow this and many may not because of bookkeeping hassles that go along with it.
If you want to use the rollover option, your best bet will be to have your employer ship the money directly to the IRA or your new employer's plan. The direct rollover lets you avoid the 20% withholding.
The advantage of the rollover is that you continue to hold the IRS at bay. Funds that otherwise would go to pay taxes remain in the account and continue to enjoy tax-sheltered growth. Choosing to roll over into an IRA gives you the most flexibility because you have almost unlimited choice among investments; if you go to another employer plan, you're choices are limited to those offered by the plan.
Even if you know you'll need to spend some of the cash right away, consider having the full amount transferred directly to an IRA. That avoids withholding. When you withdraw money from your IRA, it's up to you whether or not anything will be held back for the IRS.
Choosing an IRA rollover does prevent you from using the special averaging method. Whether that's a significant loss would depend on how quickly you'll need access to your funds. Holding off the tax bill by using an IRA for just a few years could more than compensate for skipping the chance to pay a somewhat reduced tax bill now.
Rolling over into a new employer's plan can preserve the right to averaging if you qualify for it. Or, if you have a Keogh plan —set up with self-employment income—you can also hold off the IRS and retain the right to averaging. The company-plan distribution can be rolled over tax-free into the Keogh or the new employer's plan and, if you later take a lump-sum distribution from the Keogh, it could qualify for averaging. Again, though, only taxpayers born before 1936 can qualify for averaging.
Basically, for taxpayers who qualify for ten-year-averaging, retirement benefits earned before 1974—and paid out in a qualifying lump-sum distribution—can qualify to be treated as capital gains, which might hold down the tax bill. Your employer should tell you how much qualifies. As long as you were born before January 2, 1936, you can build this capital gain twist into your forward averaging computation. Whether doing so makes sense, however, depends on the size of your distribution.
The interview for retirement income will lead you through this issue.
This special computation method taxes the distribution all at once, but the bill is figured as though you received the money over ten years. Although you must actually pay the tax right away, the amount due will be significantly less than if the full amount was heaped on top of your other taxable income.
If you were born before January 2, 1936, you can qualify for ten year averaging for a lump-sum distribution if it:
If your payout passes the test, what's the prize?
If the distribution is less than $70,000, part of it is absolutely tax-free, thanks to the "minimum-distribution allowance." This break can exempt from tax 50% of the first $20,000 of a lump-sum distribution. As the payout rises above $20,000, the tax-free portion shrinks. The maximum allowance of $10,000 is reduced by 20% of the amount by which the distribution exceeds $20,000.
The tax on the rest of the distribution is figured this way:
TaxCut, of course, handles all the math.
Consider this example. Say you receive a lump-sum distribution of $200,000. That's too big to benefit from the minimum-distribution allowance. But you benefit from averaging. One-tenth of $200,000 is $20,000. Using 1986 rates for single taxpayers, the bill on that amount is $3,692. Multiplying that by ten gives you a tax bill on the lump-sum of $36,920.
A stiff bill to be sure, but without averaging, the 2006 tax on a $200,000 lump-sum could be as high as $70,000, depending on your other income. A key privilege of averaging is that you get to take advantage of the lower tax brackets ten times. Each tenth is treated as though it were your only income for the year.
The tax using ten-year averaging could be even lower if you qualify to treat part of the payout as a capital gain and pay a flat 20% tax on that portion.
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