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Glossary
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Lump sum Distribution
Lump sum distribution as you move into
retirement can be a risky and complicated path to navigate. Even the
hardiest of accountants have cause to pause while dealing with this
topic. The tax implications can be difficult but if you are looking to
cash out of your business’s qualified retirement plan then you need to
do your research. Most employees especially those born post 1935
should think about rolling over their retirement accounts into an IRA.
This allows continued to deferral of taxes and when you are determined
you need the money all you need to do is follow the IRA withdrawals
rules.
For those employees who want to get a lump sum distribution they will
be required to pay the taxes immediately. If you were born earlier to
1936 there are numerous options for reducing taxes as opposed to a
single option offered to everyone else. The rules are complicated.
What Is a
Lump Sum Distribution?
Let us imagine you are receiving a lump
sum distribution as named by the tax law. This can be through a number
of payments presented 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 daily
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,
together with your 401k and stock bonus plans. ALL looked after by the
same company.
If your employer has a number of different
plans, you will be given a lump sum distribution if you cash out of
all those plans in the same year. On the other hand, if you receive as
an example your pension money one year and your 401k the next year, in
reality you would have two lump sum distributions in taxable from both
years. Obviously this is not a good thing so try your utmost to do
everything 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. Neither can withdrawals from
Section 457 deferred compensation plans for state and local government
employees and Section 403(b) tax sheltered annuity plans.
In addition, if you are self-employed you cannot liquidate your
retirement account as a lump sum distribution with two exceptions. 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
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You were fired, quit, or became disabled
or died
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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.
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You can have a lump-sum distribution if
you meet the requirements above however more favorable options still
will not be available to you unless
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You were born before 1936
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You participated in the plan for at least
five years. This rule is waived if you die
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You pay tax on the entire amount received
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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 care for the whole
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.
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. So at this point, you may want to
re-evaluate the IRA rollover option. If not, please keep reading.
If You
Were Born After 1935
Assuming you met all the
essentials, you were permitted to compute the tax on your lump-sum
distribution as if the income were distributed consistently over five
years — this was the so-called five-year averaging privilege. Sorry to
say, five year averaging turned into history as of the end of 1999.
These days, you must just include your lump-sum distribution as
ordinary income on page 1 of Form 1040 (on the line for pensions and
annuities). The tax kick will be much more tolerable 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 unpredictably low overall tax bill. But this favorable scenario
is not very possible. The typical outcome is that the lump-sum
distribution gets piled on top of all your other earnings. This may
drive you into higher tax brackets. Plus, the added 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 think about
rolling over your lump-sum into an IRA.
If You
Were Born Before 1936
Taxpayers in this age
bracket have quite a lot of 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 pick and
the resulting tax calculations on Form 4972 (Tax on Lump Sum
Distributions from Qualified Retirement Plans.
This is a crucial 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 negatively affected by
the income from the lump-sum distribution, if you choose either of
these methods.
Choosing the right selection will require some clever calculations on
your role. You should consider hiring a tax professional if the
numbers are substantial. Doing it yourself is not the way to save
money and could end up losing you a bucket load.
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