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:
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.
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:
IRA rollover taxed as ordinary income
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:
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: