How to Handle a Lump-Sum Distribution

Lump-sum distributions are a subject that makes even accountants queasy. The tax rules have more twists and turns than a plate of spaghetti. But if you are cashing out of your company's qualified retirement plans, it will behoove you to familiarize yourself with your options.

Most employees -- especially those born after 1935 -- will do best simply by rolling over their retirement accounts into an IRA. This will allow you to continue to defer taxes. Then, when you are ready to access the money, you will simply follow the rules for IRA withdrawals.

But employees who want to liquidate their accounts by taking lump-sum distributions will have to pay the taxes upfront. The rules are kindest to retirees born before 1936. They have several options for reducing their tax bill. Those of us born later have only one option, and it's not so great.

The rules are complex. But stick with us through the definitions, and you'll learn what you need to know.

What Is a Lump-Sum Distribution?
For purposes of this article, we assume you are getting a lump-sum distribution as defined by the tax law. This can be via several payments as long as they are all received in the same year. A lump-sum distribution can also include employer stock from a stock-bonus plan or an employee stock-ownership plan.

As you'll see, if you were born before 1936, lump-sum distributions qualify for more favorable tax treatment than garden-variety retirement-account withdrawals. However, you only have a lump-sum distribution if you receive your entire account balance in the same year from all:

· pension plans maintained by the same employer,
· profit-sharing plans (including any 401(k) plan) maintained by the same employer and
· stock-bonus plans maintained by the same employer.

If your company operates several different plans, you are assured of receiving a lump-sum distribution if you cash out of all the plans in the same year. But if you receive, say, all your pension money this year and all your 401(k) money next year, you would have two lump-sum distributions in two different tax years. That's not so good, because you can only take advantage of the favorable lump-sum distribution tax rules in one year or the other. So try to make sure you get everything in the same year.

Unfortunately, a withdrawal from IRA or SEP accounts can never be a lump-sum distribution, so it can never qualify for the special tax rules explained later. Ditto for withdrawals from Section 457 deferred-compensation plans for state and local government employees and Section 403(b) tax-sheltered annuity plans. Sorry about that.

Also, if you are self-employed, you cannot treat the liquidation of your retirement account (or accounts) as a lump-sum distribution unless you have reached age 59 1/2 or have become permanently disabled. (Dying works, too, but then you wouldn't be reading this.)

If you work for someone else, you must receive the money for one of the following reasons:

· you quit, were terminated, became disabled, died or
· you reached 59 1/2, in which case you can actually continue working and still treat your withdrawals as a lump-sum distribution.

As if this were not complicated enough, you can have a lump-sum distribution under the guidelines explained above, but it still won't qualify for the favorable special rules explained later unless:

· you were born before 1936,
· you participated in the plan for at least five years (this rule is waived if you die),
· you pay tax on the entire amount received (in other words, no tax-free rollovers of any part of your money into an IRA) 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 treat the entire 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. Watch out, however. 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 (there are some additional exceptions for IRA withdrawals, but they do you no good in this context). So at this point, you may want to reconsider the IRA-rollover option. If not, please keep reading.

If You Were Born After 1935
Assuming you met all the ground rules, you were (note the past tense) allowed to compute the tax on your lump-sum distribution as if the income were spread evenly over five years -- this was the so-called five-year averaging privilege. Unfortunately, five-year averaging became history as of the end of 1999.

These days, you must simply include your lump-sum distribution as ordinary income on page 1 of Form 1040 (on the line for pensions and annuities). The tax bite will be much more acceptable 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 surprisingly low overall tax bill. But this favorable scenario is not very likely. The usual outcome is that the lump-sum distribution gets piled on top of all your other income. This may push you into higher tax brackets. Plus, the additional 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 consider rolling over your lump-sum into an IRA.

If You Were Born Before 1936
Here is where the good news starts. Taxpayers in this age bracket have several 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 choice and the resulting tax calculations on Form 4972 (Tax on Lump-Sum Distributions from Qualified Retirement Plans).

This is a key 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 adversely affected by the income from the lump-sum distribution, if you choose either of these methods.

Obviously, you'll have to do some heavy-duty math to be sure you select the best option. Or you might want to hire a tax pro if the numbers are large. This is one area where doing it yourself could cost big bucks.