Lump Sum Distributions

Lump Sum Distributions
Tax-saving strategies for Retirement Account Withdrawals
Regarding the issue of lump sum distributions, there are several points that you should be aware of when considering withdrawal of retirement funds. Listed below are some of the pitfalls and some tax-saving strategies that can be explored to maximize your after tax net from the withdrawal, using today's federal tax code.

First, lump sum distributions from IRA's, Keogh plans, 401(k) plans, most company plans, and tax-sheltered annuities, made to persons under 59½, are subject to a 10% penalty (with some exceptions).  The 10% penalty tax on premature retirement-account withdrawals 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 (QDRO) (in which case that person will owe the resulting income tax but no 10% penalty). 

Lump sum distributions are subject to income tax in the year of distribution. Your actual federal marginal tax rate on this distribution could be as high as 35% plus any state income tax that would be due. Because of these severe penalties, care must be taken to plan the best way to withdraw the money.

Some of the ways that you may be able to limit your tax liability on the distribution are:

Rollover distributions
When withdrawing money from any of the retirement plans listed above, you have a window of 60 days from the date of distribution to roll the money over into a new plan. This allows you to avoid the 10% premature distribution penalty, and continue to defer tax on the money.

There are several options available which suit different situations:
1) In the case of someone leaving one employer for another, your company plan must generally be distributed. In this case, the proceeds of the distribution can be rolled into the plan that you are covered under with your new employer (provided the plan accepts rollover contributions). This option allows you to continue to qualify for special tax averaging on the retirement plan upon final distribution.

2) If you haven't found a new job before the 60 day deadline for rollovers, you can set up a separate IRA account specifically for this distribution. Provided you don't co-mingle the original distribution funds with any other contributions, this "conduit" account will allow you to roll these funds later into another qualified plan and still retain special tax-averaging options on this money.

3) Roll all the money into an existing IRA account. If the money is co-mingled with other IRA funds, or if the money isn't rolled into a new qualified plan, you lose the option of special tax averaging, but still retain the tax deferred status on the account.

4) Do a partial rollover. If you need to use some of the money from the distribution, and you are unable to replace all of it before the 60 day deadline, you can still do a partial rollover. This strategy allows you to defer tax and avoid the 10% penalty on at least some of the distribution. Again, because of the severe tax implications, other avenues of borrowing should be exhausted before this option is considered.

However, the manner of the rollover is critical. In the case of lump sum distributions from a company plan, (vs. IRAs, Keoghs, SEPs), employers are required to subtract a 20% backup withholding tax from distributions paid directly to the employee (i.e. you receive a check paid to you). This 20% tax is considered a taxable distribution to you, unless you make it up from other sources and roll it into the new plan. To avoid this problem, you can elect to have the whole distribution transferred directly to the new plan instead of to you.

Annuity Distributions
If you are under 59½ and elect to take the money from the plan, not as a lump sum, but as an annuity, you may be able to avoid the 10% premature distribution penalty.  The IRS permits early retirees to access their retirement funds prior to age 59 1/2 without penalty as long as they take distributions under a plan of substantially equally periodic payments (rule 72t).  Once started, these payments must continue for the longer of 5 years of their attainment of age 59 1/2.  Therefore, once a 72t distribution plan is started, these become required mandatory distributions subject to the early withdrawal penalty if ceased.   Under this arrangement, payments from the plan must be made at least once a year in a series of equal payments over your lifetime, or that of you and your beneficiary. The payments must continue for at least five years or until you reach 59½, whichever comes later. After this time limit has been met, you can elect to withdraw the balance any way you like, including a lump sum of the balance. Note that the payments received are subject to income tax in the year that they are received.

Because annuities require a projected life span, calculations to determine the amount of each payment must be done on an individual basis.

Hardship Cases
There are some circumstances where the 10% penalty may not be assessed on distributions from retirement plans. These are:
1)  Distributions to support you in the case that you become permanently disabled.
2)  Distributions made to settle a qualified domestic relations court order (QDRO)– for example, property settlements in a divorce.
3)  Distributions made to pay for medical expenses exceeding 7.5% of your Adjusted Gross Income.
4)  Distribution for qualified educational expenses or 
5)  Distribution for purchase of a primary residence (you can withdraw up to $10,000 from a traditional IRA or simplified employee pension (SEP IRA) to fund a down payment for a first-time home purchase without incurring the standard 10% early withdrawal penalty, you will still have to pay income tax on the distribution.)

If You were Born After 1935
To compute your tax, 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 impact 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 is in effect under these circumstances regardless of the current capital gains tax rate.)

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.

Reference: Practice Enhancers, Able & Co.