Defined-benefit pension plans are designed to pay out a set amount of money once you retire. These plans can be expensive for employers to maintain, and in some cases, companies may opt to offer employees early retirement to cut costs. If you accept an early pension buyout, your benefits are typically paid out in one lump sum. You'll have to pay taxes on the money, unless you roll it over to another retirement account.
Generally, your pension benefits are either fully or partially taxable, depending on how the account is funded. Typically, only the employer is responsible for putting money into a defined-benefit plan. If you didn't contribute anything to your account, you're not considered to have an investment in the contract, which makes your benefits fully taxable at your regular tax rate. If your plan allowed you to put in money using after-tax dollars, then you wouldn't pay any tax on the part of the payout that represents a return of your initial investment.
Depending on your age, you may have several options for figuring the tax due on a lump-sum distribution. If you were born before January 2, 1936, you could report part of the distribution as a capital gain and the rest as ordinary income; report part of the distribution as a capital gain and use the 10-year tax option to figure the tax due on the remaining amount; use the 10-year tax option to calculate the tax due on the whole amount; or report the entire distribution as taxable income. If you were born after that date, you'd just report the whole amount as taxable income. You should also keep in mind that lump-sum pension payouts are subject to a 20 percent federal withholding, which is taken out before the money is paid to you.
You can defer the taxes due on a lump-sum payout by rolling the money over to another retirement account, such as an IRA. Rollovers can be direct or indirect. When the money is rolled over directly, you won't be subject to the 20 percent federal withholding. The withholding applies if you roll the money over yourself, and you'll have 60 days to deposit the money into another retirement account. If you don't make up the amount that was withheld, it automatically becomes a taxable distribution.
If you don't complete an indirect rollover within the 60-day window, you'll have to report the whole amount as income on your taxes. You could also get stuck paying a 10 percent early withdrawal penalty on the money if you're under age 59 1/2. If you roll over your pension benefits to a traditional IRA, you won't pay any taxes on the money until you take it out. You can roll a lump sum into a Roth IRA, which offers tax-free withdrawals, but you'll have to report the money as income in the year the rollover occurs.
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