What Is the Most Tax-Efficient Way for Me to Take a Lump Sum Distribution?

If you receive a lump sum distribution from a qualified retirement plan, you face many challenges — especially when it comes to your tax situation. Most people have to consider the effects of two key issues: withholding and taxes.

Paying Current Taxes

If you are so inclined, you can pay current income taxes on the distribution and then spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. However, if you decide to pay current income taxes, you do have options.

First, you may treat your distribution as ordinary income. You simply add it to the rest of your income for the year. It is taxed at your current tax rate.

If you qualify, you can use special tax options that can cut the tax bill on your distribution.

The first, 10-year averaging, is similar to 5-year averaging with the exception that you must divide the distribution by 10 rather than 5. You then calculate your tax liability using the 1986 tax tables for a single filer. Ten-year averaging gives you “10 trips up the marginal rate ladder” and may save you even more in taxes, depending on the size of your distribution.

The other alternative, capital gains tax treatment, allows you to have the pre-1974 portion of your distribution taxed at a flat rate of 20 percent. The balance can be taxed under 10-year averaging, if you qualify.

To qualify for these special options, you must have participated in the qualified retirement plan for at least 5 years, and you must be receiving a total distribution of your retirement account. To qualify for 10-year averaging and capital gains tax treatment, you must have been born prior to 1936.

Special tax treatment is a one-time proposition. Once elected, future distributions will be subject to regular income taxes.

The “IRA Rollover” Strategy

If you don’t want to pay current taxes on your distribution, you may roll the distribution over into a traditional individual retirement account (IRA). Doing this will enable your retirement nest egg to continue compounding tax deferred. Taxes will be postponed until you take withdrawals from the IRA.

Rollovers must be completed within 60 days of the distribution to avoid taxes and penalties. Bear in mind that if you elect to roll over a distribution, it will not be eligible for any of the special tax treatments. You must begin withdrawing funds from your IRA by April 1st of the year after the year in which you reach age 70 ¹/2 to avoid stiff penalties.

The 20% Withholding Rule

If you receive a lump sum distribution in cash, 20 percent of your distribution will be withheld and applied toward the taxes on the distribution.

Withholding can be avoided by transferring your distribution directly from your retirement plan into an IRA or another qualified plan. The transfer must be direct; the money must not pass through your hands. You can also avoid withholding by keeping your funds with the former employer, if allowed.

Before you take any action, it would be prudent to consult with a tax professional regarding your particular situation.

This material was written and prepared by Emerald Publications.

GE 37817 (02/07)