When your pension matures, there are multiple distribution options that you can choose from. Unfortunately, many of these distribution methods result in a tax liability that reduces your payout. However, you can avoid taxes on a lump sum by rolling it over into an individual retirement account (IRA) or another eligible retirement plan. Here’s how to make it happen.
A financial advisor can help you lower your taxes by optimizing your investments with a tax plan.
Pension Payout Distribution Options
Retirees have multiple distribution options when receiving a pension. These are four common choices that retirees make:
- Single-life. Monthly payments are based on the life of the person receiving the payout.
- Joint and survivor. Payments continue until both spouses pass away. The surviving spouse may receive the full distribution or a fraction of it, depending on the pension plan.
- Life with period certain. The retiree receives lifetime income, but payments are also guaranteed for a minimum period of time in case the retiree dies quickly.
- Lump sum payout. Instead of receiving a monthly income, the retiree receives a lump sum that he or she can invest in a separate account.
Tax Treatment of Pension Distributions
The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means that they are taxed at the highest income tax rates.
The agency says that mandatory income tax withholding of 20% applies to the majority of lump sum distributions from employer retirement plans. However, this default rate may be too low depending on your tax situation.
As a retiree, when you get a lump sum pension payout, not only is this considered ordinary income, but the payout could also push your income into a higher tax bracket. And, depending on the size of the pension payout, it could trigger additional investment taxes on other sources of income. Furthermore, this could reduce your eligibility for other tax deductions and benefits.
Why Investors Choose a Lump Sum Pension Distribution
While many investors prefer the regular payments that a pension provides, it isn’t always the best decision. Some investors choose to receive a lump sum distribution instead. Here are five common reasons why:
- More control over their money. When you take a lump sum, you can make investment and distribution decisions that a pension does not offer.
- Ability to leave money to beneficiaries. With a lump sum, you can withdraw money to cover your retirement income needs and leave whatever is left to your beneficiaries.
- Fear that pension will collapse. Many pensions collapse under financial obligations owed to retirees. When this happens, the government steps in to cover pensioners, but the payouts are often reduced.
- Can shop annuity rates. When you receive a lump sum, you can still create monthly recurring income through an annuity. Instead of settling for the pension payout rates, you can shop your lump sum around to find the best rates and terms.
- Roth conversion option. With your lump sum payout in a traditional IRA, you can convert all or some of the money into a Roth IRA. While you may pay taxes on the conversion, all future earnings and withdrawals are tax-free.
How to Avoid Taxes on a Lump Sum Pension Payout
Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts. Here are two things you need to know:
20% withholding. Even if you plan on rolling over your pension payout, some companies withhold 20% for potential federal tax liabilities. This occurs when the pension company sends you a check for your pension payout.
When that happens, you only receive 80% of your lump-sum distribution. If you want the full amount of your lump sum pension invested in your retirement account, you’ll need to come up with the other 20% yourself. For investors who are able to do so, the 20% that was withheld is returned when you file your taxes.
Direct rollover option. To avoid this, do not receive the payout directly. Instead, perform a direct rollover by requesting that the money be sent directly to your retirement account at the new investment company.
This process can be tricky for some investors, so the best approach is to work with your financial advisor to complete the paperwork.
Bottom Line
Many investors choose to receive a lump sum distribution from their pension to have more control over their money, leave an inheritance or to alleviate fears of the pension running out of money. Receiving a lump sum distribution could trigger a large tax bill. To avoid this situation, consider a direct rollover of your lump sum pension distribution to an IRA or another retirement account.
Tips for Creating Retirement Income
- Pensions and annuities provide regular income that retirees can depend on. Other investments supplement these payments and grow your portfolio to offset the effects of inflation. SmartAsset’sretirement income calculatorcan help you determine how much you need to save for retirement.
- Investors work with financial advisors to create financial plans for their investment needs and goals. These customized plans factor in your current nest egg, savings rate, risk tolerance and more.Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisorswho serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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As a financial advisor specializing in retirement planning and investment strategies, my expertise lies in pension distribution options, tax implications, and retirement account rollovers. I have years of experience assisting retirees in optimizing their pension payouts, minimizing tax liabilities, and structuring their retirement portfolios for long-term financial security.
Let's delve into the concepts mentioned in the article:
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Pension Payout Distribution Options:
- Single-life: Offers monthly payments based on the recipient's life.
- Joint and survivor: Payments continue until both spouses pass away, with the surviving spouse receiving either the full distribution or a portion of it.
- Life with period certain: Guarantees lifetime income with payments for a specific minimum period.
- Lump sum payout: Provides a one-time payment that the retiree can invest separately.
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Tax Treatment of Pension Distributions:
- Pension distributions are classified as ordinary income and are taxed at standard income tax rates.
- Lump sum distributions often face a 20% mandatory income tax withholding, which may not cover the actual tax liability.
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Reasons for Choosing Lump Sum Distribution:
- More control over investments and distribution decisions.
- Ability to leave remaining funds to beneficiaries.
- Concerns about the stability of pension plans.
- Opportunity to seek better annuity rates than those provided by the pension plan.
- Potential for Roth IRA conversion, leading to tax-free future earnings and withdrawals.
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Avoiding Taxes on Lump Sum Payouts:
- Rolling over the lump sum into an Individual Retirement Account (IRA) or another eligible retirement account helps avoid immediate tax implications.
- Two critical considerations: the 20% withholding and the direct rollover option.
- Some companies withhold 20% for taxes, but the full amount can be rolled over into the retirement account by compensating for the withheld amount.
- Opting for a direct rollover prevents the withholding issue, ensuring the entire lump sum moves directly into the retirement account.
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Financial Advisor's Role:
- Financial advisors play a crucial role in optimizing investments, minimizing tax burdens, and assisting in paperwork for pension rollovers.
- Collaboration with a financial advisor is recommended to navigate complex rollover procedures effectively.
Understanding these concepts is vital for retirees seeking to make informed decisions about their pension distributions and long-term financial goals. It's crucial to consult with a financial advisor to tailor strategies that align with individual circ*mstances and retirement objectives.
