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Distributions from Your Retirement Plan

Taking a Lump-Sum Distribution: Know Your Options

The lump-sum payment option is the typical form of payout for most defined contribution plans such as profit-sharing plans or 401(k) plans. Many defined benefit pension plans also provide for a lump-sum payment option. A lump-sum distribution is an amount of money you can take as income (on which you will pay taxes), or roll over to a traditional IRA within 60 days or to another eligible plan. If your defined benefit pension plan allows you to take a lump-sum distribution, the amount you receive represents the present value of all future benefits. If you elect to receive a full lump-sum, neither you nor your beneficiary will receive any further payments from your employer's pension plan after receiving the lump-sum distribution. Lump-sum distributions require careful thought and treatment.

When it comes time to take your money as a lump-sum from your company's retirement plan, you'll have a choice to roll it over into a traditional IRA within 60 days or keep it and pay income tax on the taxable portion.

Paying Current Tax on Your Lump-Sum Payment

At retirement, you typically have the following options on how to withdraw your qualified employer retirement plan money:

  1. Pay tax on a lump-sum distribution in the year of receipt and invest the balance to generate a monthly annuity or make withdrawals only as needed.
  2. Roll over the lump-sum distribution to a traditional IRA within 60 days and receive a monthly annuity, withdraw as needed, or convert it to a Roth IRA.
  3. Elect to receive a monthly annuity from your employer.
  4. Leave the money with your current employer, and withdraw as needed, or wait until age 72 (70½ if you reached age 70 1/2 by January 1,2020) to begin minimum distributions.

Let's first compare Choices 1 and 2; that is, receiving a lump-sum distribution and paying the tax currently due versus deferring taxation of the lump-sum distribution by rolling over the proceeds to a traditional IRA. In both cases, withdrawals will be made after a specified period.

Example:

Facts: Your lump-sum amount is $200,000; pre-tax interest rate of 6%; after-tax interest rate of 4.32%, and a marginal income tax rate of 28%. The example assumes no capital gain portion, and that minimum distribution rules have not taken effect.

Choice 1: Receive a lump-sum distribution and pay tax currently. Reinvest the money and make no withdrawals until the end of the specified period.

Choice 2: Roll over the lump-sum distribution to a traditional IRA and then tax the balance as ordinary income upon distribution at the end of the specified period.

Following is the after-tax cash you would have available after 5, 10, and 15 years:

 

5 Years

10 Years

15 Years

Distribution taxed

$177,910

$219,805

$271,566

IRA rollover taxed as ordinary income

$192,704

$257,882

$345,104

Based on the above analysis, for a five-year period there is no advantage to paying the tax currently. The advantage of the assets growing in an IRA in a tax-deferred environment outweighs taking a lump sum distribution and paying the taxes. So if your intention is to invest your money for growth, the better choice is to keep the assets in a tax deferred account. Options 2, 3 and 4 in most cases are preferable to taking a lump sum and paying taxes in the distribution year. Options 2, 3, and 4 allow the money to grow tax deferred as long as possible.

Two other factors as to why you may not want to take a lump sum distribution are:

  1. The effect your distribution amount will have on the portion of your Social Security benefit that is taxed.
  2. Taking a lump-sum distribution may affect qualifying for state or local senior citizen programs, such as property tax rebates, prescription assistance programs, etc.

IMPORTANT NOTE: Keep in mind that if you take a lump-sum distribution (and pay the tax currently or roll it over to a traditional IRA within 60 days), you must take control of your retirement assets and maintain a certain rate of return throughout retirement.

SUGGESTION: There are two situations when taking a lump-sum and paying the tax currently may be advisable:

  1. If you expect income tax rates to dramatically increase in the next few years: The benefit of the lower current tax rate must be compared to the benefit of the tax-deferred accumulation of earnings under a deferral option.
  2. If you plan on moving to a high-tax state.
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Member FINRA / SIPC. Osaic and Friend Bank are not affiliated. Products and services made available through Osaic are not insured by the FDIC or any other agency of the United States and are not deposits or obligations of nor guaranteed or insured by any bank or bank affiliate. These products are subject to investment risk, including the possible loss of value.


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