The popularity of traditional pension plans is steadily declining as many employers make the switch to 401(k)s and other defined contribution plans. According to the Pension Benefit Guaranty Corporation, there are just 38,000 defined benefit pension plans still in operation, compared to a peak of 114,000 in 1985. One of the biggest motivators behind the decline is the cost of maintaining these plans. In an effort to improve their bottom line, a number of companies have opted to freeze or terminate their pension plans altogether and offer employees a lump sum payment of benefits. While getting a large amount of cash all at once can be appealing, there are some potential tax implications you need to be aware of.
How Pensions Are Taxed
Generally, your pension benefits are fully or partially taxable, depending on how your account was funded. The IRS considers your benefits to be fully taxable if you don’t have any investment in the contract. You’re not considered to have an investment if you didn’t contribute anything to the plan, your employer didn’t withhold contributions from your salary or you got back all of your contributions tax-free in prior years. Since defined benefit pensions are traditionally funded solely by the employer, it’s likely that any money you receive from a lump sum would be considered fully taxable. If your plan allowed you to put in after-tax dollars, then you wouldn’t have to pay taxes on the part of your benefits that represents a return of your initial investment.
Lump Sum Distributions
A lump sum distribution would generally be subject to your ordinary income tax rate as all as the 20 percent federal withholding requirement. This means that 20 percent of your benefits would automatically be withheld by the plan administrator. If you were born before January 2, 1936 the IRS allows you to use alternate methods to calculate your tax liability. If you qualify, you can report part of the distribution as a capital gain and the rest as ordinary income or you can use the 10-year tax option to figure out the taxes due. You could also defer any taxes due by rolling your lump sum payment over to another eligible retirement account.
Lump Sum Rollovers
There are two basic ways you can roll over a lump sum pension payment. The first option is a direct rollover, which means the plan administrator transfers the money to another retirement account for you. The benefit of doing a direct rollover is that it exempts you from having to pay the 20 percent federal withholding. If your plan doesn’t allow for direct rollovers, you can roll the money over yourself. The plan administrator will send you a check, minus the 20 percent withholding. Keep in mind that the amount that was withheld will be treated as a taxable distribution unless you make up the difference. Once you receive the check, you’ll have 60 days to deposit it into your retirement account. After the rollover is complete, you won’t have to start paying taxes on your pension benefits until you start making withdrawals. If you don’t deposit the money within the 60-day time frame, then you’ll have to report the whole amount as a taxable distribution.
Early Withdrawal Penalty
If you decide not to roll your lump sum payment or you miss the 60-day window, you may have to pay an additional 10 percent early withdrawal penalty if you’re under age 59 1/2. The IRS allows exceptions to this rule in certain situations. For example, you may be able to avoid the 10 percent penalty if you had to cash out your pension because of a total and permanent disability. In cases where your employer is offering the lump sum as part of an early retirement package, you may also be able to avoid the penalty if you’re age 55 or older at the time you retire.
Before you take a lump sum pension payout it’s important to weigh all the pros and cons. Understanding how your taxes can be impacted can help you avoid major financial headaches later on.