Guest Article
by Denise Lamaute
Employers of most pension plans are required to withhold a mandatory 20% of your lump sum retirement distribution when you leave their company. However, you can avoid this tax hit if you make a direct rollover of those funds to an IRA rollover account or another similar qualified plan. Failure to rollover the entire amount of your lump sum distribution may result in your paying unnecessary taxes on all or a portion of your retirement payout.
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment similar to the federal income taxes withheld from your pay check. It is held by the federal government as a credit toward you r tax liability for the year in which your payout was made. You can use that tax prepayment to reduce your tax liability when you file your tax return the following year, usually by April 15th. Or, if you over paid your federal taxes you will be entitled to a refund of the excess taxes withheld.
To avoid the tax hit completely on your lump sum retirement distribution, it is advisable that you contact your investment representative, banker or new employer's retirement administrator before you agree to receive your pension distribution. Establish a rollover IRA account with your investment broker or banker. My firm has established rollover accounts for several individuals. Next, instruct your pension administrator of the company that you are leaving or have left to transfer your lump sum distribution directly to your new IRA rollover account or qualified plan.
When your lump sum retirement distribution is transferred directly from one trustee to another trustee without your ever taking possession of any portion of those funds, you avoid that 20% tax withholding hit. With a direct rollover, your pension funds escape being taxed until some time in the future when you begin to withdraw from that rollover account.
Caution: should you receive a check and it is for only 80% of your retirement funds, you may wind up paying taxes if you do not take some immediate and decisive action.
How severe will that tax bite be if a entire rollover is not carried out? For any portion of your lump sum retirement distribution that is not rolled over within 60 days of receiving your retirement check, you can expect to pay taxes at your tax bracket rate. What's more, if you are under age 59 1/2 at the time you receive your retirement distribution, you will be hit with an additional tax penalty equal to 10% of any amount not rolled over within the required 60 day period. For someone truly concerned about reducing their tax bite and putting their pension funds to work prudently, a botched rollover can be costly.
For example, if you were due to receive a $100,000 lump sum distribution and your former employer withheld $20,000, you'd pay $7,600 (38% tax bracket) in taxes. If you are younger than 59 1/2, you'll be hit with an additional 10% tax penalty equal to $2,000. Your tax bill on your $20,000 will then be $9,600 versus "0" with a complete rollover.
How do you achieve a tax-free rollover when you received only 80% of your funds and you need to rollover 100% of the distribution? Well, the answer is, you must find the 20% withheld amount from some other source. In essence, the funds you rollover must equal 100% of the retirement funds paid out on your behalf. The source of that "missing" 20%, for rollover purposes, is not important so long as you place 100% of your lump sum retirement distribution amount in a rollover account within 60 days of your receiving your distribution check.
Of course, a direct rollover is the easiest method to avoid taxation on your entire lump sum retirement distribution. But, should you find yourself facing a tax bite on your funds because you are unable to rollover the entire distributed amount, try to reduce that tax bite as much as possible. At least rollover the 80% portion of your lump sum retirement distribution. Next, attempt to rollover some portion of the withheld 20%.
The key to a tax-free pension rollover is to keep your pension distribution intact in a rollover account until you reach age 59 1/2. Or, should you absolutely need to tap into your pension funds before then, do so sparingly and wisely.
Denise Lamaute, pension tax attorney and investment banker with Lamaute Capital, Inc.
8383 Wilshire Blvd.
Suite 840
Beverly Hills, CA
213-655-1560,
FAX: 213-655-8319
e-mail: BeverlyHil@aol.com
BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisem*nts published on this Web site, including the article shown above.
FAQs
To avoid the tax hit completely on your lump sum retirement distribution, it is advisable that you contact your investment representative, banker or new employer's retirement administrator before you agree to receive your pension distribution. Establish a rollover IRA account with your investment broker or banker.
How to avoid taxes on pension lump sum? ›
Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts. Here are two things you need to know: 20% withholding.
Is a pension distribution taxable income? ›
If you receive retirement benefits in the form of pension or annuity payments from a qualified employer retirement plan, all or some portion of the amounts you receive may be taxable unless the payment is a qualified distribution from a designated Roth account.
Do you pay taxes when you take money out of a pension? ›
Taxes on Pension Income
You have to pay income tax on your pension and on withdrawals from any tax-deferred investments—such as traditional IRAs, 401(k)s, 403(b)s and similar retirement plans, and tax-deferred annuities—in the year you take the money.
Are pension distributions considered earned income? ›
Minimum retirement age generally is the earliest age at which you could have received a pension or annuity if you were not disabled. Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension and are not considered earned income.
Do I have to pay taxes on a lump sum pension payout? ›
Know: You will pay taxes on your lump-sum payout. Your lump sum money is generally treated as ordinary income for the year you receive it (rollovers don't count; see below).
Should I take my pension as a lump sum or monthly payments? ›
While a pension annuity offers a fixed monthly income, a lump sum can be used for a range of purposes, including for unexpected medical expenses. If you die early, you can potentially receive more money than you would with regular payments. If invested carefully, a lump sum could also offer a passive income.
At what age do you stop paying taxes on your pension? ›
Taxes aren't determined by age, so you will never age out of paying taxes. Basically, if you're 65 or older, you have to file a tax return in 2022 if your gross income is $14,700 or higher.
Can you collect a pension and Social Security at the same time? ›
Can you collect Social Security and a pension at the same time? You can retire with Social Security and a pension at the same time, but the Social Security Administration (SSA) might reduce your Social Security benefit if your pension is from a job at which you did not pay Social Security taxes on your wages.
How do you avoid tax on annuity distribution? ›
To avoid paying taxes on your annuity, you may want to consider a Roth 401(k) or a Roth IRA as a funding source. Then, you do not pay taxes upon withdrawal since Roth accounts are funded with after-tax dollars.
Single filers with a combined income of $25,000 to $34,000 must pay income taxes on up to 50% of their Social Security benefits. If your combined income is more than $34,000, you will pay taxes on up to 85% of your Social Security benefits. Do you need help figuring out your required minimum distributions?
Why are lump sum payments taxed so high? ›
Since your regular pay and bonus pay are combined, the amount of tax taken out is on that higher lump sum because of the way your yearly salary, and therefore your tax bracket, is calculated in that paycheck.
How much money can a 70 year old make without paying taxes? ›
For retirees 65 and older, here's when you can stop filing taxes: Single retirees who earn less than $14,250. Married retirees filing jointly, who earn less than $26,450 if one spouse is 65 or older or who earn less than $27,800 if both spouses are age 65 or older. Married retirees filing separately who earn less than ...
How much federal tax is taken out of a pension check? ›
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment similar to the federal income taxes withheld from your pay check. It is held by the federal government as a credit toward you r tax liability for the year in which your payout was made.
How are pension distributions reported? ›
Form 1099-R is used to report distributions from annuities, profit-sharing plans, retirement plans, IRAs, insurance contracts, or pensions.
Will my Social Security be reduced if I have a pension? ›
Your Social Security benefit might be reduced if you get a pension from an employer who wasn't required to withhold Social Security taxes. This reduction is called the “Windfall Elimination Provision” (WEP). It most commonly affects government work or work in other countries.
Does a lump-sum pension affect Social Security? ›
Any reduction would be to your Social Security benefit, not your CalPERS pension. If you choose to take a refund of your CalPERS retirement contributions in a lump sum, Social Security will still calculate the reduction as if you had chosen to receive monthly payments for your government pension.
Why are lump-sum payments taxed so high? ›
Since your regular pay and bonus pay are combined, the amount of tax taken out is on that higher lump sum because of the way your yearly salary, and therefore your tax bracket, is calculated in that paycheck.
Can you roll a pension into an IRA without paying taxes? ›
You can avoid paying taxes on the rollover if your pension is going to a traditional IRA. You only pay taxes when you make a withdrawal if the withdrawal is going to the traditional IRA. This is different for a Roth IRA. If you set up a Roth IRA, you pay taxes when the pension is rolled over.
