The tax rules for retirement distributions are extremely complex, and uninformed decisions can jeopardize your financial position and subject you to possible IRS penalties. Tax planning for retirement plan distributions in IRA, Roth IRA, or 401k accounts should take place well in advance of the expected payout date, so that all options are available to maximize the tax benefits. Once a distribution has been made, your alternatives are much more limited on how to plan for future distributions.
Lump-sum distribution from your retirement plan
A preliminary step is to check in with your pension plan administrator. Congress changed the way pension plans value lump-sum distributions to their participants. This change could reduce the amount of your lump-sum distribution and your pension plan administrator should know if the size of your payout is affected. If, after considering your general finances and what you intend to do in retirement, you decide that receiving all your savings in a single distribution is right for you, you’ll need to plan to be sure you receive the most favorable tax treatment possible.
Roll any lump-sum distributions you receive over into an IRA
You may be able to roll any lump-sum distributions you receive over into an IRA, thus escaping any tax until you must withdraw amounts from the IRA. However, you’ll definitely want to make this decision before you receive any distribution, since the amount paid from a qualified plan is subject to mandatory 20% federal income tax withholding, even if you plan to deposit it in an IRA or other plan during the 60-day period for rollovers. You may well receive the amount withheld back at the end of the year as a refund if you complete the rollover, but you won’t be able to deposit it into the IRA at that time. Instead, you’ll be taxed on the amount withheld unless you replace it with other funds so that an amount equal to the full distribution ends up in the rollover account when you make the initial deposit.
Direct trustee-to-trustee transfer
Fortunately, you usually can avoid these negative consequences by electing a direct trustee-to-trustee transfer in which you set up an account before receiving the distribution and have your current plan transfer the amounts directly to it. Most plans are required to give you this option. Since you never receive the money, you are never subject to withholding and run no risk of being taxed until you receive a distribution from the IRA.
Elect to receive a lump-sum distribution
These are only the options available if you elect to receive a lump-sum distribution. Other factors come into play if you elect to receive your payout as some form of annuity or periodic payment, for your life, for a term of years, or for the life of you and your spouse or other beneficiary, depending on the terms of your plan and your personal situation. Considering all alternatives will help you get the most out of your retirement savings. Remember, these decisions may affect you for the rest of your life.