Exploring Your Retirement Plan Distribution Alternatives
You may not have to retire to be entitled to receive a distribution from an employer-sponsored retirement plan, such as a 401(k), profit sharing, money purchase pension, defined benefit or employee stock ownership (ESOP) plan. You may, for example, be entitled to a distribution if you are leaving your company, if your company is terminating its retirement plan, or if you are the beneficiary of a deceased plan participant.
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Regardless of when and why you become eligible for a distribution from an employer-sponsored retirement plan, what you decide to do next may well be one of the most important financial decisions you will make.
Since your qualified retirement plan (QRP) distribution could represent the largest sum of money you'll ever receive at one time, it is important to do your homework and evaluate your options before you receive your distribution. It also makes sense to consult with a financial advisor and/or tax attorney who can provide expert advice and help you select the best distribution alternative to fit your individual circumstances.
Although the number of distribution alternatives available to you will vary depending on the terms of your specific QRP, there are three common distribution alternatives:
- Annuitized Payments
- Lump Sum Distribution
Generally, when you elect an annuity form of payment from a QRP, you will receive a set monthly benefit amount either for your life (or the joint life expectancy of you and your spouse) or for a predetermined number of years. Most annuity options are structured to guarantee you (and your spouse, if you are married) will not outlive your retirement savings.
The annuity form of distribution has several distinct disadvantages to be aware of.
You generally cannot elect to modify the payment terms should your financial circumstances change.
Depending on the terms of the annuity, distributions often may cease at your death, meaning that no further benefits under the annuity contract would be paid to your heirs.
You bear the risk that the purchasing power of your annuity payments may not keep up with inflation.
Many QRPs permit the participant or beneficiary to elect to have the entire benefit amount paid in the form of a lump sum distribution. Under certain circumstances, taking a lump sum distribution may entitle you to special tax treatment. For example, when all or part of your lump sum distribution is comprised of employer securities, you may be eligible to defer taxes on the portion or your distribution that constitutes "net unrealized appreciation" (NUA) until the stock is sold.
If you elect to take a lump sum distribution from a QRP, you will generally have to decide between:
- Paying taxes on the entire lump sum distribution in the first year, or
- Rolling over part or all of the distribution to a Rollover IRA.
If you are not eligible for special tax treatment, your lump sum distribution generally will be included with your other taxable income. That means it could be subject to a federal tax rate, which could be as high as 35 percent. State income taxes also generally apply to lump sum distributions.
The third distribution option available in under many QRPs is to roll over the amount of the retirement distribution to an individual retirement account (IRA). By rolling over some or all of the distribution to an IRA, you can defer taxes on the amount rolled over and you will have the ability to decide how to invest your money.
There are significant benefits to rolling over your distribution to an IRA:
- The avoidance of what could be a hefty, immediate tax burden, allowing you to invest more money now
- The opportunity for faster accumulation of your money over time through tax-deferred growth, and the ability to invest your retirement assets any way you would like.
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Understanding the Rules
Any portion of an eligible rollover distribution that is paid directly to you is subject to mandatory 20 percent federal income tax withholding.2 And if you are younger than 591/2 at the time of distribution, you may be subject to a 10 percent early distribution penalty tax in addition to ordinary income taxes. (If you separate from service during the year you become age 55, or later, however, and then receive a distribution from your former employer's QRP, the 10 percent penalty tax will not apply.)
Making the Choice That's Right For You
To help you decide how to receive your distribution, your employer is required by law to give you written notice (at least 30 days but no more than 90 days before the distribution) describing your options, including direct rollovers. At this point it would be prudent to review the advantages and disadvantages of each distribution option with your tax and/or financial advisor and determine which option best meets your personal needs and circumstances.
If you are a non-spouse beneficiary of a deceased QRP participant, you are not eligible for the Rollover IRA option.
Certain types of distributions are exempt from the mandatory 20 percent tax withholding.