In every financial decision you make, taxes are or will become a critical factor. Taxes are a considerable factor when it comes to preparing your retirement plan. For example, you will typically be asked how you would like to receive your pension funds at retirement; in a lump sum or as an annuity stream. Both decisions have very different tax consequences.
Lump-Sum Pension
If you choose the lump sum option, the taxable portion will be the excess of the distribution over any nondeductible contributions made to the plan by the employee. This amount is generally considered ordinary income in the year of receipt, to the extent that it is not rolled over into an eligible retirement plan. When a retiree chooses a lump sum, they have three options, including:
- Taking the distribution in cash- If you choose this option, you will immediately lose a portion of your funds to taxes. You will simply have access to the net proceeds from the transaction after you have been assessed the associated tax liability for the funds withdrawn. What’s more, you will lose the benefit of tax deferral unless you reinvest the funds into a tax-favored investment.
- Rolling the distribution over into a traditional IRA- You must take the receipt and deposit the funds into a traditional IRA or other retirement plans within 60 days, or have the funds deposited directly into a traditional IRA to avoid taxation. If you are eligible, you can also convert your traditional IRA into a Roth IRA, which offers long term tax benefits as well. Be sure to review eligibility requirements before attempting such a conversion.
- Using 10-year tax averaging- You can take the lump-sum distribution and average the taxes over a 10 year period. Although you must still pay the tax liability in the first year, you can spread the tax liability over a ten year period which can reduce your tax rate, offering you substantial savings over time. Generally the larger your lump-sum payment, the lower the tax savings.
When choosing how you would like to receive your retirement funds, you must consider a number of variables. While you may be able to decipher all of your available options on your own, it is always recommended that you consult both an investment advisor and a tax advisor to ensure that you are aware of all tax liabilities and eligibility requirements for each of your available decisions.
Are you considering withdrawing funds from your retirement account? Give us a call to review the tax strategies involved so you make a wise financial decision