What Is a Lump-Sum Distribution?

Definition & Examples of a Lump-Sum Distribution

Senior couple reviewing retirement paperwork

 fstop123 / Getty Images

A lump-sum distribution is a financial term that usually refers to an election to receive a 401(k) plan or pension benefit as a one-time payment for the entire balance. Instead of taking the payments throughout retirement, you can cash out the entire policy at once.

When deciding to transfer a qualified retirement plan, taking a lump-sum distribution is usually one of at least three choices, including a rollover, partial distribution, or keeping the benefit in the current account for as long as the plan or account custodian allows. Taking a lump-sum distribution is not often the best choice for an individual, but it can be a good option in some cases.

What Is a Lump-Sum Distribution?

Because a lump-sum distribution can have major tax consequences, it's helpful to see exactly how the IRS defines it:

"A lump-sum distribution is the distribution or payment, within a single tax year, of a plan participant's entire balance from all of the employer's qualified pension, profit-sharing, or stock bonus plans. All of the participant's accounts under the employer's qualified pension, profit-sharing, or stock bonus plans must be distributed in order to be a lump-sum distribution."

This situation can happen when the plan holder elects to take a lump-sum payment, or happen in a few other circumstances, including:

  • Death of the plan participant
  • The participant reaches age 59 ½ (early retirement age)
  • The employee participant terminates employment
  • If a self-employed participant becomes "totally and permanently disabled'"

How a Lump-Sum Distribution Works

With any retirement fund, you can leave your money in until you reach retirement age, cashing it all out at once, or rolling it over into a new or existing retirement account. If you leave an employer that's been funding a 401(k), they may not allow you to keep the money in their fund indefinitely.

If you do decide to take everything out as a lump sum, there can be significant tax consequences. For this reason, Individuals who cash out are faced with the decision of what to do with that distribution—either take it in the form of cash (check payable to you, the individual) or take it in the form of a rollover (check written to your new IRA custodian on your behalf).

Options for Your Lump-Sum Payout

The best way to frame this decision is, to begin with, what not to do with your hard-earned and well-saved retirement plan money.

Avoid Cash or Check Payable to You

If you can avoid it, you don't want to receive your distribution as a direct payout to you. When you do this, the distribution becomes taxable.

This tax status is because your 401(k) contributions, in most cases, were deducted from your paychecks on a pre-tax basis—they've never been taxed. For example, suppose your 401(k) balance is $10,000—assuming you have earned 100% vesting or ownership of your benefit—and you decide to "cash it out" and take a check payable to you. In that case, the amount you receive will be significantly less than $10,000 after taxes.

In most cases, 20% of the cash distribution will be withheld for federal taxes, which leaves you with an $8,000 check. You may even owe more if you fall in a higher tax bracket. On top of that, you may be faced with a 10% tax penalty if you withdraw the money before turning 59 ½.

Roll Over the Funds

The best thing you can do with your 401(k) is to choose the IRA rollover option. This rollover may still technically be a lump-sum distribution but, instead of receiving a check payable to you, you will receive a check payable to your IRA custodian.

For example, let's say you open an IRA with Vanguard Investments. When you have terminated employment with your employer, and you receive your 401(k) distribution options, you will select the option that says something like "Rollover to IRA." The check will be written to Vanguard Investments (not to you). If done correctly, the check will also say FBO [your name], which means "for the benefit of."

When the rollover check is made payable to Vanguard, you do not constructively receive the money, which in tax accounting terms means you didn't receive the cash, and you don't pay taxes or penalties on the distribution.

If you were born before January 2, 1936, you have additional options for how to treat your lump-sum distribution. You may be able to report a portion of it as capital gains (for funds you paid into before 1974), and you can spread your tax liability on the lump sum over 10 years.

Best Way to Invest a Lump Sum of Cash

Once your rollover distribution check arrives at your IRA custodian, you now have cash in your IRA that needs to be invested. You have two basic choices:

If you want to invest it all at once, you should be careful to diversify (spread risk over several different investments) and build a portfolio of mutual funds.

If you want to reduce market risk, you can dollar-cost average (DCA) into your chosen mutual funds by investing a set amount of dollars per month over a certain period, such as 12 months. This way, if the market fluctuates significantly, you will buy some shares at higher prices and some shares at lower prices, thus averaging out your costs. DCA especially works best when prices are high and expected to fall. Most investors will find this more effective than trying to time the market.

The Balance does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.

Key Takeaways

  • A lump-sum distribution is the payment of the full balance of a 401(k), pension, or another retirement account within a single tax year.
  • This can be taken as a cash payout or rolled over into another retirement account.
  • Tax consequences can be significant but will vary depending on the lump-sum recipient's age and how they take the payout.