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The money you put into your retirement accounts is meant to provide a steady stream of income when you're no longer working. For a variety of reasons we'll unpack shortly, however, you may need to withdraw your funds in full along the way. A lump-sum distribution is a one-time payment of the entire balance of your retirement account within a single tax year.
Taking a lump-sum payment could trigger serious tax implications, so it's important to understand how a lump-sum distribution could impact your finances. Let's take a closer look at how it all works.
How a Lump-Sum Distribution Works
A lump-sum distribution is exactly what it sounds like. Instead of making periodic withdrawals from your tax-deferred retirement account, you tap the full balance in one shot. Lots of investors prefer to keep retirement account distributions to a minimum, which allows the majority of your funds to stay invested and continue growing. It also reduces your tax burden—withdrawals from tax-advantaged accounts like 401(k)s and traditional IRAs are taxed as ordinary income. What's more, distributions taken prior to age 59½ will likely trigger an extra 10% penalty.
Having said that, there are certain situations where a lump-sum distribution may be in order. For example:
- You have a 401(k) and no longer work for the employer that sponsored it.
- You've reached age 59½ and simply wish to take out your full balance.
- The plan participant passes away and the balance is being inherited by a beneficiary.
- The participant is self-employed and becomes totally and permanently disabled.
- You were born before January 2, 1936 and can leverage 10-year forward averaging. This could reduce your tax liability and even keep you in a lower tax bracket.
If you decide to move forward with a lump-sum distribution, you'll have several options in terms of next steps.
- If you keep the distribution, the amount will be taxed as ordinary income. As previously mentioned, you're also likely to incur a 10% penalty if you're younger than 59½.
- You can rollover the funds into an individual retirement account (IRA). If the money is sent directly to your new plan provider, you'll avoid paying taxes on the distribution. You'll also sidestep that 10% early withdrawal penalty. If you receive the distribution as a direct payment to yourself, you'll have 60 days to roll it over. Otherwise, it will be treated as a taxable distribution.
- You can funnel the lump-sum distribution right into a different 401(k) with a new employer. It works the same way as an IRA rollover. Just bear in mind that the 60-day rule applies here as well.
Pros and Cons of Taking a Lump-Sum Distribution
Pros
- Leaving an old 401(k) with a previous employer won't do much to grow your wealth. Using a lump-sum distribution to roll it over into a new qualified account can help you build on those savings and keep that money actively invested for retirement.
- Taking a lump-sum distribution could free you up to make different investment choices. Depending on your financial goals, age and risk tolerance, you may wish to redirect this money toward other investments that could ultimately render better returns.
- If you're over 59½, a lump-sum distribution could make sense if you're faced with a significant financial emergency and need those funds now. You'll still have to pay taxes on it, but it's something to think about.
Cons
- Since 401(k)s are funded with pretax dollars, your distributions are taxable. Taking a lump-sum distribution could result in a large tax bill that eats into your wealth. The size of the distribution could even be enough to push you into a higher tax bracket.
- Keeping your money invested allows you to benefit from compound interest. While you can't avoid market volatility, staying the course could help your nest egg keep pace with inflation. It's a different story if you pull your money out via a lump-sum distribution. While the stock market has seen an average annual return of almost 10% over the last century, rates for high-yield savings accounts are only hovering at around 0.70% to 1% at the time of this writing.
- Again, if you take a lump-sum distribution prior to age 59½, you might also get hit with a 10% penalty. To give you an idea of the impact, that's $10,000 on a $100,000 distribution.
Should You Take a Lump-Sum Distribution?
The decision to take a lump-sum distribution depends on your unique financial situation. It could make sense to someone who has funds sitting in an old 401(k) that could be put to good use. Rolling it over into a traditional IRA or new 401(k) allows you to keep that money invested and working hard for you.
On the flip side, those who choose to keep the funds from a lump-sum distribution could face a substantial tax burden and potential early withdrawal penalty. Remember that these distributions count as taxable income for the year. As such, it could nudge you into a higher tax bracket—elevating your tax burden even more.
When it comes down to it, there isn't one black-and-white answer to whether taking a lump-sum distribution is a wise financial move. An experienced financial professional can help you evaluate your overall financial health so that you can make the best decision for your needs.
The Bottom Line
If you do choose to roll a lump-sum distribution over into a new tax-deferred account, note that you must begin taking required minimum distributions beginning at age 72. Generally speaking, minimizing your distributions can ease your tax burden in retirement. That's where other retirement income sources—like Social Security benefits and money in non-taxable accounts like a Roth IRA—can be helpful. They could diversify your income so that you're less dependent on taxable accounts.
Lump-sum distributions represent one key part of retirement planning. Keeping your financial health going strong along the way is crucial. Free credit monitoring from Experian is built with that goal in mind. It's a simple way to keep tabs on your credit, no matter where you are on the road to retirement.