Lump-Sum Distributions from Employer-Sponsored Retirement Plans

For income tax purposes, a lump-sum distribution is the withdrawal of your entire balance in a retirement plan in one taxable year. Although the name implies that a lump-sum distribution is a single payment, that is not necessarily the case. The number of payments you receive doesn't matter. Rather, it is the time period — one taxable year — that is critical. You can receive many payments in the same taxable year and still have those payments qualify as a lump-sum distribution, as long as you receive your entire plan balance in one taxable year.

Consider your options carefully before taking a lump-sum distribution. Having your plan balance paid out to you in one taxable year can result in a considerable income tax bill, possibly pushing you into a higher income tax bracket for the taxable year. (If you qualify, however, special lump-sum distribution income tax rules may reduce the tax due.) Keep in mind that you may face not only federal and state income tax, but also a 10% federal premature distribution tax (and possibly a state penalty) if you are under age 59½.

Additionally, the drawbacks of taking a lump-sum distribution go beyond taxes and penalties. By withdrawing your retirement assets from the employer-sponsored plan, those assets will no longer benefit from tax-deferred growth in the plan. And, you may end up spending this retirement money before you retire because not only have the funds been physically removed from a retirement plan and possibly commingled with your regular, everyday funds, but you may also no longer think of these funds as being allocated for a specific purpose — funding your retirement.

Caution: Special rules apply to distributions from Roth 401(k), Roth 403(b), and Roth 457(b) accounts. In general, qualified distributions from these accounts are entirely free from federal incomes taxes, and nonqualified distributions are subject to tax only to the extent of any earnings distributed.

With a lump-sum distribution, your retirement plan assets are paid out to you in one taxable year and you don't roll those assets over to an IRA or another employer's retirement plan. The distribution is subject to income tax (and possibly penalties) for the year in which it is received, and the funds no longer enjoy tax-deferred growth in the plan.

With a rollover, although a lump sum of money may be distributed from the plan, it is transferred (either directly or indirectly) to another retirement plan or to an IRA. Rollovers allow you to move your plan assets from one savings vehicle to another without taxes or penalties (assuming all rollover rules are followed). Rollovers also encourage prolonging retirement savings by allowing the tax-deferred accumulation of the funds to continue in a tax-deferred IRA or new plan.

First, you must participate in a plan that allows lump-sum distributions. Lump-sum distributions are typically available to participants in qualified retirement plans (such as 401(k) plans). However, availability ultimately depends upon the IRS regulations and the provisions of your employer's retirement plan. Not all retirement plans have the same provisions regarding lump-sum distributions. Consult your plan administrator or benefits officer, or your summary plan description (SPD), to find out whether you may take a lump-sum distribution.

In addition, to qualify for a lump-sum distribution, you must meet two requirements:

1. Within one taxable year, you receive your entire balance from all of your employer's retirement plans of the same kind (profit-sharing and 401(k) plans, pension plans, stock bonus and ESOP plans), and
2. The distribution was made under one of the following conditions:

• You were at least age 59½ at the time of the distribution
• You were an employee who separated from service with the employer (due to layoff, resignation, retirement, or disability)
• You were self-employed and became totally and permanently disabled

You receive your entire balance in the plan

Unlike retirement plan distributions that are spread out over time, the entire balance of your employer-sponsored retirement plan is paid to you within one taxable year when you take a lump-sum distribution. You can reinvest this lump-sum payment elsewhere, such as in an annuity or taxable mutual funds, if you choose. You can also use it to meet expenses such as large medical bills, your child's college tuition, or the down payment on a home purchase. Since this is a taxable distribution to you, however, be sure to keep enough in reserve to pay income taxes and possibly penalties.

Special tax elections may be available

The income tax consequences of a lump-sum distribution can be significant, so it is often better to instead roll over your plan assets to defer taxation. However, if you are certain that you want to take a lump-sum distribution, special tax elections may be available to help ease the tax burden. These include 10-year income tax averaging and special capital gains treatment. To find out if you might qualify for one of these elections, see below and consult a tax advisor.

You eliminate future involvement with the plan

You may be dissatisfied with the administration of your employer-sponsored retirement plan. You may also be disappointed with the performance of your plan investments and the limited selection of investment choices. Or, you may simply no longer want to have any contact with the plan of a former employer. A lump-sum distribution eliminates any future involvement with the former employer's retirement plan, allowing you to reinvest the funds where you choose.

You may have to pay more income tax

With a lump-sum distribution, you receive all of your retirement plan money in one taxable year instead of spreading distributions over several years. Unless you have ever made after-tax contributions to your plan, the entire lump-sum distribution will be treated as taxable income. Having more taxable income in one year will cause you to pay more federal (and probably state) income tax for that year. This may be especially true if the distribution pushes you into a higher income tax bracket, causing the funds to be taxed at a higher rate. The additional income may also bring a phaseout (reduction) of income tax deductions and exemptions. By comparison, distributions spread out over time also spread out your income tax payments over a longer period. Paying income tax on the entire distribution in one taxable year also means that less of the money is available to invest elsewhere once taxes are paid. For more information on the taxation of lump-sum distributions, including special elections that may reduce taxes, see below. As you can see, the interplay of various income tax factors and long-term retirement considerations with lump-sum distributions means that it makes good sense to get professional advice before taking a lump-sum distribution.

You may be subject to early withdrawal penalties

If you take a lump-sum distribution (or any other type of distribution) from your retirement plan before you reach age 59½, you may have to pay a federal early withdrawal penalty known as the premature distribution tax. This penalty is in addition to regular federal income tax, and is equal to 10% of the taxable portion of a distribution. Some states also impose their own early withdrawal penalties, so check your state's laws. If your lump-sum distribution is large, the combined impact of taxes and penalties may be substantial. If you need a lump-sum distribution and are close to age 59½, consider waiting until you reach 59½. In some cases, you may have no choice. If your vested balance is below $5,000, your plan does not have to allow you to leave funds in the plan.

Tip: The IRS allows a number of specific exceptions to the federal early withdrawal penalty. Of particular importance to this discussion, the penalty tax does not apply to distributions you receive upon separation from service, if your separation occurs during or after the year you turn age 55 (age 50 for qualified public safety employees participating in certain state or federal governmental plans).

Caution: Premature distributions from SIMPLE IRA plans are subject to a 25% penalty tax during your first two years of participation (10% thereafter).

Your retirement funds are removed from a tax-deferred plan

Not only will a lump-sum distribution result in taxes and perhaps penalties, but it could also cost you future retirement investment earnings. To understand why, consider that funds held in a qualified retirement plan benefit from the power of tax-deferred growth. No tax is due as long as the funds remain in the plan. Thus, more funds are available that have the potential to grow tax deferred. Depending on investment performance, the long-term effects can be dramatic due to the power of compounding.

By contrast, once you receive a lump-sum distribution from your plan, this tax-deferral benefit is lost. You can invest the funds elsewhere, but you will have to pay income tax every year on the earnings (unless you invest in another tax-advantaged vehicle).

There are four basic steps to follow if you want to take a lump-sum distribution from your retirement plan:

1. Consult your plan administrator to determine whether a lump-sum distribution is available to you. Remember, not all plans allow this option.
2. Consider all of your other options before taking a lump-sum distribution. Lump-sum distributions can have a negative long-term impact on your retirement planning, as well as your tax liabilities.
3. Request a distribution form from your plan administrator, complete the form, and submit it. Note that you may be required to obtain your spouse's written consent to the distribution.
4. Adjust your estimated taxes if necessary, include the amount you receive on your income tax returns (federal and state) for the year of the distribution, and determine if you qualify for special income tax treatment. It is best to consult a tax professional, since tax consequences can vary depending on several factors.

Income tax is generally assessed on all lump-sum distributions from a retirement plan, regardless of your age or employment status. This is because contributions to the plan usually are made on a pre-tax basis and the investment earnings accrue tax deferred. This means that the fund balances have usually not been previously taxed. However, there are some cases where part of a lump-sum distribution may not be subject to income tax:

• After-tax contributions you made to the plan (amounts that have already been taxed before being invested in the plan — since they've already been taxed, they will not be taxed again when distributed to you)
• Repayments of loans from the plan that were included in your taxable income
• The net unrealized appreciation of any employer securities that were distributed as part of a lump-sum distribution, unless you elected to be taxed on this appreciation
• The value of any annuity contract included in the lump-sum distribution
• Premiums paid by the plan for life insurance on you to the extent those premiums were included in your gross income

In almost all other cases, a lump-sum distribution is treated as a fully taxable distribution to you for federal (and possibly state) income tax purposes. The distribution will increase your taxable income for that year, potentially pushing you into a higher federal income tax bracket. In addition, if you are under age 59½, the taxable portion of your distribution may be subject to the 10% federal premature distribution tax on early withdrawals (and possibly a state penalty, as well), unless one of several potential exceptions applies.

The following hypothetical scenario illustrates the possible tax impact of a lump-sum distribution. In this case, after income tax and the 10% penalty tax for early withdrawal, the individual receives a net distribution of roughly half of his or her plan balance.

Caution: It is bad enough to owe significant income tax on distributed funds. It is even worse if you lack the money to pay it when the tax is due. If you take a lump-sum distribution, note that your plan administrator will be required to withhold 20% of the distribution for federal income tax. However, the amount withheld may not be sufficient to cover all of your income tax liability on the distribution. Make sure you will have the funds available to pay the difference when you file your federal income tax return for the year.

Tip: In some cases, a lump-sum distribution may qualify for special tax treatment such as 10-year averaging or capital gains treatment or the employer securities appreciation federal tax rules. Consult a tax advisor regarding these rules and how they might apply to you.

Caution: Distributions from IRAs, SEP IRAs, and SIMPLE IRAs are not eligible for any of the special tax treatments discussed here. In addition, the special tax treatments discussed here do not apply to 403(b) plans or 457 plans.

Employer securities — net unrealized appreciation

With a distribution of retirement assets other than employer securities, the entire distribution is generally subject to federal income tax in the year of distribution. When the distribution includes employer stock or other securities, however, you need to pay income tax only on a portion of the distribution and, in addition, you may receive a considerable income tax benefit in the future.

A distribution of employer securities consists of two parts: (1) the cost basis (that is, the value of the security when it was contributed to, or purchased by, your plan) and (2) any increase in value over the cost basis until the date the security is distributed to you. This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.

At the time of a lump-sum distribution, you may elect to pay income tax on just the amount of the original cost of any employer securities. Income tax on the NUA is then deferred until you sell the stock at a later date. NUA as of the date of distribution is taxed as long-term capital gain, no matter how short a period you hold the securities outside of the plan. However, any subsequent gain in value is taxed as short-term or long-term capital gain, depending on how long you own the stock from the date of distribution until the date of sale.

Example(s): You retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan. The cost basis in the stock, determined by the plan, is $50,000. The $450,000 ($500,000 minus $50,000) gain is NUA. You sell the stock ten years later, when it's worth $750,000. At that time, you'll pay long-term capital gains tax on your NUA ($450,000). You'll also pay long-term capital gains tax on the additional appreciation ($250,000), since you held the stock for more than one year. Note that since you've already paid tax on the $50,000 cost basis, you won't pay tax on that amount again when you sell the stock.

Caution: If you are not age 55 or disabled at the time you receive your lump sum distribution, the 10% premature distribution tax penalty will apply to the cost basis that you include in your taxable income at the time of distribution. However, the 10% penalty will not apply to the NUA portion of your distribution, or to any additional appreciation in the value of the securities.

Tip: If your distribution includes cash in addition to the securities, you can either roll the cash over to an IRA or take it as a taxable distribution. And you don't have to use the NUA strategy for all of your employer securities — you can roll a portion over to an IRA and apply NUA tax treatment to the rest.

The following requirements must be met to exclude NUA from taxable income:

• You must receive a distribution of your entire balance, within a single tax year, from all of your employer's qualified plans of the same type (that is, all pension plans, all profit-sharing plans, or all stock bonus plans)
• The distribution must be paid after you reach age 59½, or as a result of your separation from service, or after your death (unlike 10-year averaging and the special capital gains treatment, you are not required to have participated in the plan for five years)

Technical Note: The amount of the NUA (if any) should be shown in Box 6 of Form 1099-R. Part of the amount in Box 6 will qualify for capital gains treatment if there is an amount in Box 3 of Form 1099-R. Use the NUA Worksheet in the instructions for Form 4972 to determine the part that qualifies for capital gains treatment. For more information about NUA, see IRS Publication 575.

If you die while you still hold employer securities in your retirement plan, your plan beneficiary can also use the NUA tax strategy if he or she receives a lump-sum distribution from the plan. The taxation is generally the same as if you had received the distribution. (The securities don't receive a step-up in basis, even though your beneficiary receives them as a result of your death.) If you've already received a plan distribution, elected NUA tax treatment, and die before you sell the securities, your heir will have to pay long-term capital gains tax on the NUA when he or she sells the securities. However, any appreciation as of the date of your death in excess of NUA will forever escape taxation because, in this case, the securities will receive a step-up in basis. Using the example above, if you die when your employer stock is worth $750,000, your heir will receive a step-up in basis for the $250,000 appreciation in excess of NUA at the time of your death. If your heir later sells the stock for $900,000, he or she will pay long-term capital gains tax on the $450,000 of NUA, as well as capital gains tax on any appreciation since your death ($150,000). The $250,000 of appreciation in excess of NUA as of your date of death will be tax free.

Compare to installment distributions

With distributions in installments, you generally pay income tax at ordinary income tax rates on the entire distribution. With a lump-sum distribution of employer securities, you pay ordinary income tax only on the cost basis portion of the securities — the balance (the NUA) is later taxed at the lower capital gains rate.

When this special election may reap substantial benefits

When the cost of the employer securities is relatively small and the NUA is (or may become) large, receiving a lump-sum distribution with this special election may be more beneficial than taking periodic payments of your benefits, rolling over your benefits, or utilizing 10-year averaging. Consult your tax advisor.

Special 10-year averaging and capital gains treatment

Special 10-year averaging or capital gains treatment may apply if you were born before 1936. Consult a qualified professional.