Lump sum suggests the comforting image of a mass of money — a bulwark against financial perils. If you invest it wisely, you have the opportunity to shore up the future by beating inflation, which causes fixed income to lose its value. What’s more, you don’t have to worry about your pension plan going bust or your former employer changing pension policy. But you may need to be concerned about decreasing assets or poor performance.
HOW LUMP SUM PAYMENTS WORK
Some but not all employers allow lump-sum distributions. If you take a lump-sum distribution from a defined benefit plan, your employer determines how much you would receive if the plan paid you an annuity over your projected lifespan, and then calculates how much the pension fund could have earned in interest on that amount during the years of your payout.
- Can use money immediately
- Can make your own investment decisions
- Easy to spend too fast
- Taxes due immediately on lump sum
- Owe additional taxes on investment gains
- Defer taxes until you withdraw funds
- Make your own investment decisions at your own pace
- Enjoy potential for tax-deferred growth
- May pay more taxes in the long run
- Risk spending too quickly
- Must begin withdrawals by 70½
Your lump-sum share is what you would have been entitled to, reduced by a factor of the projected interest earnings, known as the discount rate.
If interest rates are high, your lump sum will be smaller than in a period of low interest as a result of the way the calculation is done. If your retirement date is flexible, you may want to wait if you think interest rates are going down. Once you have the lump sum, the responsibility for investing it to make it last through your retirement is yours.
In contrast, if you take a lump-sum distribution from your defined contribution plan, such as a 401(k) or a 403(b), the assets in the plan are sold and the cash, minus transaction costs, is yours. The amount that has been invested and the return those investments have provided determine the value of your account. The current state of the investment markets matters here as well. In a flat or falling market, your payout will be less than in a growth phase.
MAKING IT LAST
You can use the same discount rate the company uses to calculate your lump sum as a guide to how well you’re doing with your investments. If your investments are growing at the same rate or better, you should be on track. But if your money is earning less than that percentage, you may come up short of the income you need to live on.
Unless you plan to spend the bulk of your payout right away — a decision you’ll want to weigh carefully unless you have other sources of retirement income — you generally come out ahead by transferring the money to a rollover IRA rather than taking the lump-sum distribution and putting it into taxable investments, assuming that you could get the same rate of return on both portfolios. With a rollover IRA, you preserve the tax-deferred status of your account. But if you take the distribution as cash, tax on the entire amount will be due for the year you received the money, plus a potential 10% tax penalty if you are younger than 59½. The tax is calculated at your regular income tax rate, which is determined by your filing status and taxable income.
A WORD OF CAUTION
Remember that all investments carry risk, and that the return is not guaranteed. So you might come up short if you do not achieve the return you expect from the investments you select because of a downturn in the financial markets.
INVESTING A LUMP SUM
One challenge in investing a lump-sum payment in a taxable account is determining how to put your assets to work without feeling that you’re rushing or making snap decisions. It is true that the sooner you invest, the more potential your principal has to grow. But that advantage can disappear if you haven’t developed a strategy for building a diversified portfolio and selecting appropriate investments.
One approach, if you aren’t planning to begin taking income from the investment in the next few years, is to choose some stocks, stock mutual funds, and exchange traded funds (ETFs) that focus on long-term growth. If those investments perform as you expect, you can sell them at a profit at some point in the future. Then you’ll owe tax on any increase in value at the lower long-term capital gains rate rather than at your regular income tax rate.
On the other hand, if you want to invest to produce current income, you might consider putting some of the payout into municipal bonds. Though the interest rate these bonds pay is typically lower than what you could earn on similarly rated corporate bonds, the income is free of federal tax and, in some cases, of state and local tax as well — though it may be subject to the alternative minimum tax (AMT). You might also consider dividend-paying stocks that qualify to have the dividends taxed at your long-term capital gains rate. That includes most US stocks and many international ones. Check the details with your tax adviser.
MOVING TO AN IRA ROLLOVER
You can move the money from your pension to an IRA in two ways:
- You can get a check for the money, just as you would if you were taking a lump-sum payout and deposit the full amount in the IRA within 60 days of receiving the check, in what’s known as an indirect transfer
- You can have the money transferred directly to the custodian of your IRA
If your retirement plan includes stock your employer contributed, you may want to consider taking the stock as a lump sum distribution instead of rolling it into an IRA. You’ll pay income tax on your basis, or the stock’s value when it was added to the account, and capital gains tax if you sell. But that could cost you less than paying income tax at your regular rate on the stock’s increased value as you sell it within your IRA and withdraw the proceeds.
The advantage of an indirect transfer is that you can use the money for 60 days. That flexibility can be outweighed by the fact that your employer must withhold 20% of the amount before writing you a check
You get the 20% back when you file your income tax return for the year, but not quickly enough to meet the redeposit deadline. That means you have to come up with the missing money from other sources so you can put the full amount in your IRA.
Any amounts you don’t deposit within the time limit are considered withdrawals and are taxed at your regular rate. If you’re younger than 59½, you may also owe a 10% early withdrawal tax penalty in addition to income taxes. There is an exception if you’re over 55 and have stopped working. Then the penalty, but not the income tax, is waived.
When the money is transferred directly, nothing is withheld, and you don’t have to worry about missing the 60-day deadline. That makes it the method of choice for many people. It can also reduce any temptation to spend the money.