A lump-sum distribution usually refers to an election to receive the entire balance in a 401(k) plan or a pension plan as a one-time payment. Instead of taking the payments throughout retirement, you cash out of the plan at once.
When deciding whether to transfer the money into another qualified retirement plan, taking a lump-sum distribution is usually one of a few choices: a rollover, a 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 often not 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 know exactly how the IRS defines it. Though a lump-sum distribution is often taken all at once, multiple payments that make up the entire balance of a plan can be collectively considered a lump-sum distribution if they take place within a single tax year.
The plan in question may also be a profit-sharing or stock bonus plan.
A lump-sum distribution may also be paid because of the plan participant's death; after the participant reaches age 59½; because the participant, if an employee, quits their job; or after the participant, if self-employed, becomes totally and permanently disabled.
How Does a Lump-Sum Distribution Work?
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 individual retirement account (IRA) or some other qualified retirement plan. If you have left the employer that's been funding your 401(k), you may not be allowed to keep your money in the company plan indefinitely.
If you do decide to take everything out as a lump sum, there can be significant tax consequences. For this reason, those who cash out are faced with the decision of what to do with that distribution—either take it in the form of cash (a check payable to you) or in the form of a rollover (a check written to your IRA or other plan custodian on your behalf).
What Are My Options for the Lump-Sum Payout?
The best way to frame this decision really is to focus on what not to do with your hard-earned and well-saved money.
Avoid a 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 new tax status comes into play because your 401(k) contributions, in most cases, were deducted from your paychecks on a pre-tax basis; they've never been taxed.
For instance, suppose your 401(k) balance is $100,000 and you have earned 100% vesting or ownership of your benefit. Should you decide to "cash it out" and take a check payable to you, the amount you receive will be much less than $100,000 after taxes.
In most cases, 20% of the cash distribution will be withheld for federal taxes, which leaves you with an $80,000 check. On top of that, you may be faced with a 10% tax penalty if you withdraw the money before turning 59½. That would leave you with a $70,000 check.
You are subject to the 20% tax withholding when you directly receive a cash distribution even if you intend to roll it over into another retirement plan within 60 days. If you complete the rollover within the IRS time limit, you may use outside funds to restore the withheld amount and defer the payment of the tax.
If you fail to complete the rollover within 60 days, you may be able to claim that you qualify for a waiver of that requirement.
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 be a lump-sum distribution, but instead of receiving a check payable to you, either you will receive a check payable to your IRA custodian or your custodian will receive the check directly.
For example, let's say you open an IRA with Vanguard. When you have stopped working for 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 (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 instead of you, you do not pay taxes or penalties on the distribution. That's because you were never in receipt of the money at any point.
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.
What Is the Best Way to Invest a Lump Sum of Cash?
Once your IRA custodian has the rollover check, you now have cash in your IRA that needs to be invested. You have two basic choices: Invest it all at once or invest it in increments over time.
If you want to invest it all at once, you should take care to diversify (spread your risk over several different types of investments), perhaps through a portfolio of mutual funds.
If you want to reduce market risk, you can use dollar-cost averaging (DCA) to invest a set amount of money per month into your chosen funds over a certain period, such as a year. This way, if the market fluctuates widely, you will buy some shares at higher prices and some shares at lower prices, thus averaging out your costs. Most investors will find DCA to be more effective than trying to time the market.
DCA works best when prices are high and are expected to fall.
- A lump-sum distribution is the payment of the full balance of a 401(k), pension, or another retirement account all at once or within a single tax year.
- It 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.