Plans for lump-sum distributions

If you receive a lump-sum distribution from a qualified retirement plan, you face many challenges — especially when it comes to your tax situation. Most people have to consider the effects of two key issues: withholding and taxes.

-Paying current taxes:

If you are so inclined, you can pay current income taxes on the distribution and then spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. However, if you decide to pay current income taxes, you do have options. First, you may treat your distribution as ordinary income. You simply add it to the rest of your income for the year and is taxed at your current tax rate. Or, if you qualify, you can use special tax options that can reduce the tax bill on your distribution. Those special options are only available for certain people, however, so you should contact your tax professional to see if you qualify.

-“IRA rollover” strategy:

If you don’t want to pay current taxes on your distribution, you may roll the distribution over into a traditional individual retirement account (IRA). Doing this will enable your retirement nest egg to continue compounding tax deferred. Taxes will be postponed until you take a withdrawal from the IRA. Rollovers must be completed within 60 days of the distribution to avoid taxes and penalties.

-The 20 percent witholding rule:

If you receive a lump-sum distribution in cash, 20 percent of your distribution will be withheld and applied toward the taxes on the distribution. Withholding can be avoided by transferring your distribution directly from your retirement plan into an IRA or another qualified plan. The transfer must be direct; the money must not pass through your hands. You can also avoid withholding by keeping the funds with your former employer, if allowed.

Before you take any action for any of these tax strategies, it would be prudent to consult with a tax professional regarding your particular situation.