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Lump-sum distributions.

The wrong decision can be costly.

If you’re retiring or changing careers, then it’s probably time to decide what to do with the funds in your 401(k) or other type of employer-sponsored qualified retirement plan. Your decision on how to receive your qualified plan distribution can have significant consequences however, including whether or not you’ll be able to live comfortably in retirement. Naturally, you want to protect what you’ve accumulated during your years of hard work.

There are a number of options available; depending upon how you choose to build your portfolio, though, your distribution could be subject to a variety of taxes and penalties. A brief explanation of these pitfalls appears below (ideally, you’ll want to select options that not only meet your retirement needs but also minimize the impact of taxes and penalties).

Tax pitfalls.

Here are several potential tax issues that can arise when you receive a lump-sum distribution:

  • State and federal income taxes will take a “bite” out of your distribution. When you were making contributions to your 401(k), you most likely did so with pretax dollars. In addition, employer contributions to a qualified plan on your behalf were also tax deferred. Upon distribution, you’ll have to pay current income taxes on all pre-tax contributions and earnings.
  • Arguably, the most sizable tax issue is the mandatory 20% federal income withholding tax that is applied to eligible rollover distributions. If you elect to receive a check directly from your employer, you will only receive 80% of your distribution. In essence, if you expect to receive a check for $100,000, your employer will withhold 20%, or $20,000, and send you a check for $80,000.
  • There is also a 10% early withdrawal tax (also known as a premature distribution penalty) that will be imposed on the entire distribution if you are under age 59½, unless the withdrawal is due to death or disability or taken in substantially equal periodic payments. Certain other exceptions may apply.
Direct rollover.

One way to avoid the 20% mandatory withholding tax, as well as current income taxes, is to directly roll your entire distribution into another qualified employer plan or Individual Retirement Account (IRA). An IRA is a tax-deferred account that can be used to receive retirement benefits distributed from an employer-qualified plan. And, since all earnings continue to accumulate on a tax-deferred basis, your money will compound and accumulate more rapidly than money placed in an otherwise identical taxable account.

When considering an IRA, many individuals have been attracted to the benefits of a self-directed IRA. This type of IRA gives you the power and flexibility to shift your investments as your goals and economic conditions change. Investments in an IRA can include stocks, bonds, money- market funds, government securities, unit investment trusts and mutual funds.

If for some reason you have already received your lump-sum distribution, minus the 20% withholding tax, you’ll still have options. To begin with, you have 60 days from the date you received your payout to invest these funds into an IRA or qualified plan, along with an additional 20% of your own money to cover the taxes withheld (you’ll also receive credit for the 20% withheld when you file your income tax return). Remember, you only have 60 days to complete this process. If you don’t act in a timely manner, your entire payout will be subject to both state and federal income taxes, and, unless an exception applies, the 10% early withdrawal penalty tax.

To establish a direct rollover IRA, ask your former employer’s plan administrator (in writing) to transfer the funds to the trustee of the new qualified plan or IRA. The plan administrator must provide you with the opportunity to make a direct rollover.

Transfer funds to your new employer’s plan.

If your new employer’s plan accepts rollovers from another employer’s plan, you can transfer the funds directly to its 401(k) plan or other type of qualified employer plan, avoiding current income taxes and the 20% withholding tax.

Establish a conduit IRA.

If there’s a waiting period for participating in your new employer’s plan and you do not want to leave funds with your former employer, ask your former employer to transfer your retirement account to a conduit IRA. A conduit IRA is designed specifically for temporary rollovers, to keep them separate from any other IRA funds you possess.

Keep funds in your old employer’s plan.

For account values of $5,000 or more, you may want to keep funds in your employer’s plan until you reach the plan’s retirement age or age 62, whichever is later, if that is an option. Because of the nature of the plan, your funds will continue to accumulate tax-deferred and can later be moved to a new employer’s qualified plan or an IRA without penalty. If you are over the plan’s retirement age or age 62, your company may insist that you take a payout in order to decrease the plan’s administrative costs. If this happens, you still have the option to make a direct rollover to an IRA.

Periodic withdrawals.

This option may be suitable if you need funds to supplement your retirement income. The 20% mandatory tax withholding rules do not apply if your distribution is part of a series of substantially equal periodic payments that are made at least once a year and will last for:

  • Your lifetime, or
  • Your lifetime and your beneficiary’s lifetime, or
  • A period of ten years or more.

Keep in mind that the funds you receive will be subject to current income taxes. If you choose the “10-years-or-more” payment option and you are under age 59½, you may be subject to the 10% early withdrawal penalty tax. If you are already receiving fewer than 10 annual payments, 20% of what you expected in a given year (and in future years) will be withheld. To avoid this, instruct your plan administrator to transfer the payments directly into an IRA. You can then establish a payout schedule to avoid the mandatory withholding tax.

Lump sum in company stock.

(Note that when employer stock is distributed in a lump-sum distribution, you pay ordinary income tax on the cost basis of the stock. The excess of the fair market value of the stock over the cost basis—the net unrealized appreciation—is taxed at long-term capital gains rates when the stock is eventually sold.)

Some plans may allow you to take your lump-sum distribution in company stock. If your distribution consists of such stock, the mandatory 20% withholding tax will not apply. You’ll still need to pay regular income tax, however, and you may also be subject to the 10% early withdrawal penalty if you’re under age 59½. One way to avoid this is to ask the plan trustee to sell the stock and put the proceeds into an IRA within 60 days from the time you receive your lump-sum distribution. By doing this, you’ll not only avoid current income taxes, you’ll also bypass the early withdrawal penalty.

Don’t lose out—get the facts.

When considering rolling over the proceeds of your retirement plan to another qualified option such as an IRA, Roth IRA, or other type of qualified account, you have two options: leaving the funds in your existing plan, or transferring them into a new employer’s plan. You should consult with the Human Resources Department of the applicable employer to learn about the options available under your plan and any applicable fees and expenses. Tax consequences may apply if you were to withdraw the funds, and there are additional tax consequences for transferring stock out of your retirement plan.

Also, depending on the state where you reside, assets held in a retirement plan may enjoy greater protection from creditors than other types of tax-qualified vehicles. Plus you should consider the different types of fees and services that apply to your plan and compare them to any new option you are considering.

Whatever you choose to do, be sure you know the rules, tax consequences, and potential penalties, so you can make an informed decision.

Lump-sum distributions.

Contact New York Life today to arrange an appointment with a NYLIFE Securities LLC. Registered Representative to discuss investment alternatives for your lump-sum distribution. There is no cost or obligation. However, because of the tax ramifications of your decision, be sure to consult with your tax advisor before any decision is made.

NYLIFE Securities LLC (Member FINRA/SIPC) is a wholly-owned subsidiary of New York Life Insurance Company.
This material is for informational purposes only. Neither New York Life nor its Agents provide tax, legal, or accounting advice. Please consult your own tax, legal, or accounting professional before making any decisions.