What Is a Lump-Sum Distribution?

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DEFINITION

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.

Definition and Examples of a Lump-Sum Distribution

Taking a lump-sum distribution means withdrawing the entire balance of your retirement account at once rather than taking smaller distributions over time. 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.

A lump-sum distribution can also happen:

  • When the plan participant dies
  • Once the participant turns 59½
  • Because the participant leaves the employer that is sponsoring the retirement plan
  • After a self-employed individual becomes permanently and totally disabled

The plan in question may also be a profit-sharing or stock bonus plan.

Taking a lump-sum distribution is usually one of a few choices that you will have. You can also roll the balance of the account over into another retirement plan, take a partial distribution, or keep 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, because it can have serious tax consequences. 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, but in some cases, it may be the best choice.

How Does a Lump-Sum Distribution Work?

Usually, if you have money in a retirement account, you keep most of the money there to continue earning interest. Then, once you stop working, you take periodic distributions as part of your retirement income.

In some cases, though, you may not be able to leave the money in your retirement account. If you have left the employer that's been funding your 401(k), for example, 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. Your options, in that case, are to take it either in the form of cash (a check payable to you) or in the form of a rollover (a check written to your IRA or another plan custodian on your behalf).

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 that, 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. This means they've never been taxed.

In most cases, 20% of the cash distribution will be withheld for federal taxes. Out of a $100,000 distribution, that would leave 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 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, suppose 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 personally). If done correctly, the check will also say "FBO [your name]," which means "for the benefit of [you]."

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 actually 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.

How to Invest a Lump-Sum Distribution

Once your IRA custodian has the rollover check, you will 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). You can do that 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 mutual funds over a certain period, such as a year. That way, if the market fluctuates widely, you will buy some shares at higher prices and some shares at lower prices. That would average out your costs and use your money more effectively. Most investors will find DCA to be more effective than trying to time the market.

Key Takeaways

  • 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 your age and how you take the payout.

Article Sources

  1. Internal Revenue Service. "Topic No. 412 Lump-Sum Distributions."

  2. Internal Revenue Service. "Topic No. 413 Rollovers From Retirement Plans."