A lump-sum distribution can be described as a single lump-sum payment made from an amount of money owed to an individual instead of payments broken down into smaller parts. In certain circumstances, the distribution of lump sums can be granted specific tax benefits. They are usually related to the choice of how to take advantage of windfall gains like winning the lottery or from a pension or retirement plan. Lump-sum distributions may be contrasted against annuitized payouts.
Working
Typically, if you have funds in a retirement savings account, you'll keep most of them to earn interest. After you have stopped working, you receive periodic payments as part of your pension income. In some instances, you might not be able to transfer the funds into your retirement accounts. If you've resigned from the company that funded your 401(k), for instance, the company you worked for, you might not be able to keep your funds in your company's plan for an indefinite period.
If you choose to pay everything in an all-in-one lump sum, there could be tax consequences that could be substantial. The options in this situation are to receive it as cash (a check made payable at your address) or as an IRA rollover (a check made payable into the account of your IRA or another custodian of your plan on behalf of you).
Avoid a Check Payable to You
If you can do so, you shouldn't receive the distribution directly to you. If you do this, the distribution is tax-deductible. The new tax status applies because the 401(k) contributions generally were taken out of your pay on an untaxed basis. That means that they've not been taxed.
In the majority of instances in the majority of cases, 20% of the money distribution is taken to pay federal tax. In the case of a distribution of $100,000, this leaves you with a check of $80,000. In addition, you could be hit with a tax of 10% penalty if you take out the funds before turning the age of 59 1/2. You would then have the equivalent of a check for $70,000.
You will be subject to 20 percent tax withholding if you receive a cash payout, regardless of whether you plan to transfer it into other retirement plans within 60 days. If you finish this rollover in the specified period, you can use other funds to pay back the amount withheld and delay the tax payment.
Annuity Payments vs. Lump-Sums
Imagine you have won $10 million from the lottery. If you were to take entire winnings in lump sum, the entire prize is tax-exempt during the year, and you'd be in the tax bracket with the highest rate. If you decide to go with an annuity plan, payments can be paid over some time. For instance, instead of $10 million in income for one year, your annuity payout could be $300,000 per year. Even though the $300,000 will be subject to taxation on income, it could keep you from the state tax brackets with the highest rates. Also, you would be able to avoid the highest federal income tax bracket, which is 37 percent (as of 2020) for individuals with earnings of more than $518,400 (or $622,050 for couples who file jointly.
In 2021, these numbers increased. Individuals earning more than $523,600, as well as a couple of filing jointly earning incomes of up to $628,300, are within the 37% tax bracket. Tax questions about these categories are based on the magnitude of the winnings from the lottery, current tax rates, anticipated income tax rates, the state of residence when you win, the state you'll be living after winning, and the return on investment. However, if you can make an annual income greater than 3%-4 percent, then the lump sum option is usually more beneficial by purchasing a 30-year annuity. Another major benefit of taking a lump sum is that it gives winners the benefit of a "do-over" credit card. With a regular check each year, the winners are more likely to manage their money well, even if it's a rough first year.
How to Invest in a Lump-Sum Distribution
When your IRA custodian can issue an IRA rollover, you'll have funds in your IRA which need to be put into an investment. There are two options to invest it all at once or make it an investment in smaller incremental increments throughout the time. If you're planning to invest all of it in one go, diversify (spread your risk across different kinds and types of investing). This can be done by creating an investment portfolio that includes mutual funds.
