Seniors, Here’s How to Avoid Taxes on Lump Sum Pension Payouts

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

When your pension matures, there are multiple distribution options that you can choose from. Unfortunately, many of these distribution methods result in a tax liability that reduces your payout. However, you can avoid taxes on a lump sum by rolling it over into an individual retirement account (IRA) or another eligible retirement plan. Here’s how to make it happen.

A financial advisor can help you lower your taxes by optimizing your investments with a tax plan.

Pension Payout Distribution Options

Retirees have multiple distribution options when receiving a pension. These are four common choices that retirees make:

  • Single-life. Monthly payments are based on the life of the person receiving the payout.

  • Joint and survivor. Payments continue until both spouses pass away. The surviving spouse may receive the full distribution or a fraction of it, depending on the pension plan.

  • Life with period certain. The retiree receives lifetime income, but payments are also guaranteed for a minimum period of time in case the retiree dies quickly.

  • Lump sum payout. Instead of receiving a monthly income, the retiree receives a lump sum that he or she can invest in a separate account.

Tax Treatment of Pension Distributions

The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means that they are taxed at the highest income tax rates.

Because pension distribution taxes can be so high, investors wisely seek out ways to reduce taxes on this income.

When a retiree receives a lump sum pension payout, not only is this ordinary income, but the payout could push their income into a higher tax bracket. Depending on the size of the pension payout, it could also trigger additional investment taxes on other sources of income. Additionally, it could reduce their eligibility for other tax deductions and benefits.

Why Investors Choose a Lump Sum Pension Distribution

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

While many investors prefer the regular payments that a pension provides, it isn’t always the best decision. Some investors choose to receive a lump sum distribution instead. Here are five common reasons why:

  • More control over their money. When you take a lump sum, you can make investment and distribution decisions that a pension does not offer.

  • Ability to leave money to beneficiaries. With a lump sum, you can withdraw money to cover your retirement income needs and leave whatever is left to your beneficiaries.

  • Fear that pension will collapse. Many pensions collapse under financial obligations owed to retirees. When this happens, the government steps in to cover pensioners, but the payouts are often reduced.

  • Can shop annuity rates. When you receive a lump sum, you can still create monthly recurring income through an annuity. Instead of settling for the pension payout rates, you can shop your lump sum around to find the best rates and terms.

  • Roth conversion option. With your lump sum payout in a Traditional IRA, you can convert all or some of the money into a Roth IRA. While you may pay taxes on the conversion, all future earnings and withdrawals are tax-free.

How to Avoid Taxes on a Lump Sum Pension Payout

Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts. Here are two things you need to know:

20% withholding. Even if you plan on rolling over your pension payout, some companies withhold 20% for potential federal tax liabilities. This occurs when the pension company sends you a check for your pension payout.

When that happens, you only receive 80% of your lump-sum distribution. If you want the full amount of your lump sum pension invested in your retirement account, you’ll need to come up with the other 20% yourself. For investors who are able to do so, the 20% that was withheld is returned when you file your taxes.

Direct rollover option. To avoid this, do not receive the payout directly. Instead, perform a direct rollover by requesting that the money be sent directly to your retirement account at the new investment company.

This process can be tricky for some investors, so the best approach is to work with your financial advisor to complete the paperwork.

Bottom Line

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

SmartAsset: How to Avoid Taxes on Lump Sum Pension Payout

Many investors choose to receive a lump sum distribution from their pension to have more control over their money, leave an inheritance or to alleviate fears of the pension running out of money. Receiving a lump sum distribution could trigger a large tax bill. To avoid this situation, consider a direct rollover of your lump sum pension distribution to an IRA or another retirement account.

Tips for Creating Retirement Income

  • Pensions and annuities provide regular income that retirees can depend on. Other investments supplement these payments and grow your portfolio to offset the effects of inflation. SmartAsset’s retirement income calculator can help you determine how much you need to save for retirement.

  • Investors work with financial advisors to create financial plans for their investment needs and goals. These customized plans factor in your current nest egg, savings rate, risk tolerance and more. Finding a qualified financial advisor doesn’t have to be hard.  SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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