Lump-sum distributions can be taken four ways

by Bruce Chrisope

for the Business Journal

Many companies today are giving their employees the option of taking a lump-sum distribution from their retirement plans when they leave a company or retire.

Having what may be a substantial sum of money all at once can give you a false sense of wealth. You now have to deal with such issues as taxation, your continued plans for retirement and your prospects that could easily cut into your nest egg.

For many people, receiving a lump-sum distribution can be a temptation. You may think you "deserve" that new car, an expensive vacation or, perhaps, you want to be generous with gifts to family members.

You may be under the misconception that the sum is large enough to last forever. Or, if you are not yet ready for retirement, you may rationalize that you still have the opportunity to build up another retirement fund at another company.

These reactions are typical. A recent Department of Labor study reveals that among workers age 40 and older who received lump-sum distributions, only 32 percent rolled over their distribution. That percentage sinks to 16 percent for those under age 40.

There seems to be little recognition among the general population that a lump-sum distribution comprises funds that were built up over the years and should remain earmarked for retirement.

One pervasive myth is that retirement represents just a small portion of your life. The reality is that we're all going to live longer, on average, than our grandparents did. Most retirees can expect to live another 20 to 30 years.

This is not bad news. It simply means that the dollars you save during your working years must sustain you during your retirement years more years

than many of us may have been anticipating.

Then, there is the curse of inflation, which has averaged 3.1 percent over the period from 1925 to 1996, according to U.S. Department of Labor statistics. What does this mean for your retirement?

If, for example, you decide that a certain dollar amount will support your lifestyle when you retire at age 65, then in 20 years you will need nearly triple that income to maintain this same standard of living.

What steps can you take to better prepare for a secure and comfortable retirement? Since the largest single source of retirement funds will most likely come from your company's retirement plan, such as a 401(k), it's important to understand your options when you receive a lump-sum distribution.

Basically, there are four alternatives available to you:

1. You may elect a direct rollover into an IRA.

2. You may take receipt of the funds and then perform a rollover within 60 days.

3. You may roll over a portion of the funds.

4. You may elect to receive the funds and pay current taxes on the distribution.

Here's how a lump-sum distribution of $100,000 adds up under each scenario, if you receive it when you are under age 59 1/2:

Choice 1: direct rollover into an IRA

If you transfer your distribution to an IRA or another qualified plan, your entire distribution will continue to grow tax-deferred.

$100,000 plan distribution

0 withholding of taxes

0 taxes owed

$100,000 total rolled over into an IRA.

If you take your entire distribution in cash, you will pay taxes on all gains and income in the distribution, and will probably pay a 10 percent tax penalty if you are under age 59 1/2.

As you can readily see, you can keep as much as $100,000 of your distributions or only about half that amount (assuming you are in the tax bracket used in these examples), depending on the decisions you make.

It's clear that the tax laws surrounding lump-sum distributions can be complex. Retirement planning is a lifelong process, and you will likely encounter equally complicated decisions regarding distributions from your IRAs and perhaps additional lump-sum distributions throughout your lifetime.

How can you manage this distribution process effectively? A prudent course is to seek professional help from a tax adviser, estate-planning attorney and a financial consultant before making any decision, which in many cases could be irrevocable.

Once you run your own numbers and match them with your present situation and future goals, then you can see for yourself what choice is best in your individual circumstances.

The bottom line is that your future, and that of your family, depends on the intelligent retirement planning decisions you make today to preserve the value of your lump-sum distributions.

(Bruce Chrisope is a financial consultant with Smith Barney in Springfield.)

INSET CAPTION:

For many people, receiving a lump-sum distribution can be a temptation. You may think you 'deserve' that new car, or an expensive vacation.

Choice 1: direct rollover into an IRA

If you transfer your distribution to an IRA or another qualified plan, your entire distribution will continue to grow tax-deferred.

$100,000 plan distribution

0 withholding of taxes

0 taxes owed

$100,000 total rolled over into an IRA.

Choice 2: 60-day rollover

If you take your distribution and roll it over within 60 days, you will have to add back the 20 percent your employer was required to withhold in order for your entire distribution to continue growing tax deferred.

$100,000 plan distribution

($20,000) 20 percent mandatory withholding*

$80,000 distribution received

$20,000 withheld amount replaced with your own funds

$100,000 total rolled over within 60 days

* $20,000 may be refunded at tax time

Choice 3: partial rollover

If you roll over part of your distribution and take the remainder, you will defer taxes on the portion you roll over, and pay taxes, and possibly incur a penalty for early withdrawal if you are under age 59 1/2, on the portion you take.

$100,000 plan distribution

($20,000) 20 percent mandatory withholding

$80,000 distribution rolled over within 60 days

$20,000 20 percent withheld

$9,200 income tax on 20 percent withheld and not rolled over*

$10,800 potential refund after taxes

$80,000 amount rolled over into an IRA

*Assumes 36 percent tax bracket with 10 percent early withdrawal penalty

Choice 4: receive funds and pay current taxes

$100,000 plan distribution

($20,000) 20 percent mandatory withholding

$80,000 distribution received

($26,000) Income tax owed in addition to the 20 percent withheld*

$54,000 amount of distribution you might have after taxes

*Assumes 36 percent tax bracket with 10 percent early withdrawal penalty[[In-content Ad]]