Taxes on Partial Lump Sum Retirement Payments
Employer-sponsored retirement plans are designed to help you grow your nest egg while enjoying some tax advantages. The plan's structure determines whether you can make monthly withdrawals or a lump sum payment once you're ready to retire. Plans that allow lump sum distributions may give you the option of making partial or full withdrawals. If you're thinking of cashing out part of your retirement account, it pays to understand the potential tax implications.
Pension Tax Rules
Your retirement benefits are either fully taxable or partially taxable, depending on the kind of plan you're enrolled in. The Internal Revenue Service considers your benefits to be fully taxable if you don't have a direct investment in the account. Defined-benefit plans, for example, are typically funded only by the employer, which means you'd have to pay taxes on all the money in your account when you take it out. If you chipped in after-tax dollars to your employer's plan, you wouldn't pay any taxes on the part of the distribution that represents a return of your initial investment.
If you're taking a partial lump sum from a retirement plan that you didn't directly contribute to, then all the money you take out is taxable at your regular rate. Depending on your age, you may have several options for calculating the amount of tax due. If you're cashing out part of your balance from a 401(k) or a similar account, the amount of tax you owe depends on the type of contributions you made to the plan. Typically, these kinds of plans allow you to chip in pre-tax dollars, which means you'd have to pay taxes on the money once you take it out. If your plan also allowed you to put in after-tax money, then you'd be able to withdraw these funds tax-free.
Withholding and Penalties
In addition to regular income tax, lump-sum distributions are also subject to a 20 percent federal withholding. You can opt out of paying the withholding, but it could mean a bigger tax bill when it's time to file your return. If you're under age 59 1/2 at the time that you take a lump sum payment, you may have to pay an additional 10 percent early withdrawal penalty, depending on whether you qualify for an exemption or not. The IRS does allow exceptions for certain situations. For instance, you may not have to pay the penalty if you took a partial cashout of your retirement account because you suffered a total and permanent disability.
If you're planning to take a partial lump sum payment but you don't want to get hit with a big tax bill, you can defer any taxes due by rolling the money over to another retirement account. You can ask for a direct rollover, which means your plan administrator will transfer the money to the new account for you. If you go this route, you won't have to pay the 20 percent federal withholding. If you decide to roll over the money yourself, you'll have to pay the withholding, and you'll only have 60 days to complete the rollover. If you don't, you'll have to report the whole distribution as taxable income.
Rebecca Lake is a freelance writer and virtual assistant living in the southeast. She has been writing professionally since 2009 for various websites. Lake received her master's degree in criminal justice from Charleston Southern University.