Pensions, Lump Sums & Taxes

A traditional pension provides a lifetime of monthly income payments for retirees. However, pensions may offer other options to retirees, including paying a lump sum distribution in lieu of ongoing payments. Taking a lump sump distribution may trigger a significant tax liability unless the retiree places the funds in another qualified retirement plan.

Defined-Benefit Plans

A pension is a defined-benefit retirement plan. Employers, and possibly employees, contribute to a pension fund throughout the employees' careers. A pension fund is a single pool of money that pays benefits to retirees according to a defined formula based upon a number of factors, including the employee's compensation and length of service.

Payment Options

Many pension plans offer different pay-out options upon retirement. Traditional plans, such as annuities, pay out a monthly benefit for the life of the retiree. Another common option is a reduced monthly payment for the longer of the employee's or the spouse's life. Some pension plans offer the employee the option of taking a single lump sum distribution from the pension plan in place of regular monthly payments. The formula a plan uses to calculate the available lump sum distribution is defined by the plan and is equal to the upfront cost of providing monthly payments to retirees based upon actuarial assumptions about the employees' lifespans.

Tax Considerations

Employer contributions entirely fund most pensions, creating fully taxable payouts. Any after-tax employee contributions, such as those that many government-sponsored pensions may require, create no taxes when distributed. When you begin taking payments, the plan administrator computes the tax-free portion of each monthly payment and that portion stays constant for the life of the payouts, even if the payments increase. Administrators calculate the taxable amounts using Worksheet A of Internal Revenue Service Publication 575. For lump sum distributions, the taxable amount is the amount of the distribution minus the total amount that the employee contributed to the plan.

Avoiding Taxes on Lump Sum Distributions

A sizable lump sum distribution can create a significant tax bill. You can postpone taxes on a lump sum distribution by rolling the distribution into a qualified retirement plan, such as an IRA or an annuity. In this case, you don't incur taxes until you withdraw funds from the rollover retirement plan.

Early Withdrawals

Lump sum withdrawals from a qualified pension plan before age 59 1/2 may be subject to a 10 percent tax penalty in addition to ordinary income taxes. Payments prior to age 59 1/2 that qualify as substantially equal periodic payments from the retirement plan may be exempt from the 10-percent penalty.

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