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If you receive a lump-sum distribution from your qualified employer-sponsored retirement plan , the federal income tax bite can be substantial. Usually, the taxable part of your distribution is subject to tax at ordinary rates. In addition, a large distribution can push you into a higher marginal income tax bracket. You may be able to minimize your tax hit, though, if you were born before 1936 and qualify to elect special tax treatment. If you're eligible, you can figure your income tax on the distribution using the 10-year averaging method and/or the special capital gains tax rules. These methods may save you considerable tax dollars. Additionally, special rules may apply if your lump-sum distribution includes employer securities.

Caution: Special tax rules apply to distributions from Roth 401(k) and Roth 403(b) accounts. Qualified distributions from these accounts are entirely free of federal incomes taxes. Nonqualified distributions are taxable only to the extent attributable to earnings on your contributions.

What Is a Lump-Sum Distribution?

For federal income tax purposes, a lump-sum distribution is the distribution or payment in one tax year of your entire balance (excluding deductible voluntary employee contributions and certain forfeited amounts) in all qualified employer-sponsored retirement plans of the same type with the same employer. Examples of qualified retirement plans include pension, profit-sharing, and stock bonus plans. To receive special income tax treatment, the distribution must be made for one of these four reasons:

  • You are at least age 59½
  • You were an employee who separated from service with the employer (layoff, retirement, or disability)
  • You were self-employed and became totally and permanently disabled
  • You are a beneficiary of a deceased plan participant

Ordinarily, you think of a lump-sum distribution as being just one payment to you. But that's not the case for the tax definition of this term. It's not the number of payments that's so important; instead, it's the time period--one taxable year--that's critical. You can receive many payments in the same taxable year and have them qualify as one lump-sum distribution as long as you receive your entire plan balance in one taxable year.

For instance, if you received several distributions from your 401(k) plan this year, the total amount could qualify as a lump-sum distribution (assuming all other requirements are met) as long as you received your entire plan balance in one tax year.

Can You Roll Over a Lump-Sum Distribution and Still Qualify for the Special Tax Treatment?

No. With a lump-sum distribution, your money is paid out to you in one taxable year and you don't roll it over to an IRA or another retirement plan. Therefore, the funds no longer enjoy tax-deferred growth. With a rollover, a distribution from your retirement plan is transferred to another retirement plan or IRA. Rollovers encourage retirement savings by allowing you to continue the tax-deferred accumulation of the funds and their earnings.

If You Were Born Before 1936, How Do You Report a Lump-Sum Distribution for Federal Income Tax Purposes?

Qualifying lump-sum distributions receive favorable federal income tax treatment. Assuming you keep the lump-sum distribution (and don't roll it over to an IRA or other qualified plan) and meet all the requirements, you may have four options for reporting the taxable portion:

  • You can use the 10-year averaging method to figure the tax on the total taxable amount of the distribution
  • You can report the part of the distribution from participation in the plan before 1974 as a capital gain, and use the 10-year averaging method to figure the tax on the part from participation after 1973
  • You can report the part of the distribution from participation in the plan before 1974 as a capital gain, and the part from participation after 1973 as ordinary income
  • You can report the entire taxable part of the distribution as ordinary income on your tax return

What Is the 10-Year Averaging Method?

The 10-year averaging method, which is available only if the plan participant was born before 1936, is a special formula for calculating the federal income tax due on the ordinary income part of a lump-sum distribution from a qualified employer-sponsored retirement plan. You pay this tax only once--the year in which you receive the distribution; it's not paid over the next 10 years.

If you qualify for 10-year averaging, you'll compute the income tax due on your lump-sum distribution on IRS Form 4972. Essentially, you calculate the tax on one-tenth of the taxable portion of your distribution, using 1986 income tax rates for single filers. You then multiply this tax by 10. (The 1986 income tax rates are found in the instructions to Form 4972.) You add that tax to the regular tax figured on your other income (line 40 of Form 1040).

Tip: The amount of a distribution subject to 10-year averaging is taxed separately from other income you may have. Therefore, depending on the amount of the distribution, it may not be taxed at your highest marginal income tax rate.

Tip: Because your adjusted gross income (AGI) doesn't include distributions calculated according to the 10-year averaging method, AGI-sensitive tax breaks won't be adversely affected by the income from your lump-sum distribution.

What Are the Eligibility Requirements for the 10-Year Averaging Method and the Special Capital Gains Tax Treatment?

To qualify for 10-year averaging and/or the special capital gains tax treatment, the following requirements apply:

  • The plan participant (whether alive or dead in the year of distribution) must have been born before 1936.
  • The plan participant must have received the distribution after belonging to the plan for at least 5 tax years. Exception: The 5-year rule doesn't apply if the distribution was paid because of the plan participant's death.
  • The plan participant (or the beneficiary) must elect to use the 10-year or capital gains tax treatment (and this election can generally be made only once). So, if you elected 5-year or 10-year averaging or the capital gains tax treatment in the past, you probably don't qualify for special tax treatment again. However, if you made the election before 1987 and were under age 59½ at that time, you can make the 10-year or capital gain election once again if you meet all of the other requirements.
  • The lump-sum distribution must be from a qualified employer-sponsored plan (such as a pension plan, profit-sharing plan, or stock bonus plan), and must represent the participant's entire balance in all plans of that type maintained by that employer (e.g., all profit-sharing plans with that employer).
  • The distribution(s) must be paid to the plan participant (or to his or her beneficiaries) within a single taxable year.

Tip: Multiple beneficiaries may share a qualified lump-sum distribution. If so, one or all of the beneficiaries may use the 10-year averaging method and/or the capital gains tax treatment. Form 1099-R should indicate the percentage of ownership that each beneficiary has in the distribution. For more information, see the instructions to Form 4972.

Tip: If you're involved in a divorce and receive a qualified lump-sum distribution under a qualified domestic relations order (QDRO), you may also be eligible to use the 10-year averaging method to calculate the income tax on your distribution. (Again, the plan participant must have been born before 1936.)

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Which Distributions Do Not Qualify for This Special Tax Treatment?

The following distributions do not qualify as lump-sum distributions for purposes of the 10-year averaging treatment and/or the special capital gains tax treatment.

  • Distributions from IRAs, including simplified employee pension (SEP) IRAs and savings incentive match plan for employees (SIMPLE) IRAs
  • Distributions from Section 457 deferred compensation plans
  • Distributions from Section 403(b) tax-sheltered annuities
  • Lump-sum credits or payments from the Federal Civil Service Retirement System or the Federal Employees Retirement System
  • Distributions that are rolled over (in part or in full) to another qualified plan or an IRA (this means that if you roll over part of a distribution, no portion of the distribution--whether rolled over or not--will qualify for special tax treatment)
  • Distributions from a retirement plan if you have previously received a distribution from that plan and rolled it over, in full or in part, to another qualified plan or IRA
  • Distributions from a retirement plan if you have rolled over any amount to the plan after 2001 from an IRA (other than a conduit IRA), a governmental Section 457 plan, or a Section 403(b) tax-sheltered annuity (and after your death, your surviving spouse must not have rolled over any amount from another qualified plan)
  • U.S. Retirement Plan Bonds distributed with the lump sum
  • The current actuarial value of any annuity contract included in the lump sum (the payer's statement should show this amount)
  • A corrective distribution of excess deferrals, excess contributions, excess aggregate contributions, or excess annual additions
  • Certain distributions to five percent owners that were subject to IRS penalties (see IRS Publication 575 for more information)

For more information about these exceptions, see IRS Publication 575 and the instructions to Form 4972.

How Often Can You Use the Lump-Sum Distribution Tax Treatment?

In general, a plan participant can use the special lump-sum distribution tax treatment only once after 1986. There are a couple of exceptions, though.

  • If you're the beneficiary of a deceased plan participant and elect to use the special tax treatment, you may still qualify to use the special tax treatment on distributions from your own plan. If you're the beneficiary of qualified lump-sum distributions from more than one qualifying person, you can also elect to use the special tax treatment for each distribution.
  • If you made an election for the special tax treatment on Form 4972 before 1987 and were under age 59½ at the time, you can make the election once again (assuming you meet all of the other requirements).

What Is the Capital Gain Election for Pre-1974 Participation?

Capital gain treatment applies only to the taxable part of a lump-sum distribution resulting from participation in a qualified retirement plan before 1974. The amount treated as capital gain, found in box 3 of the Form 1099-R sent to you, is taxed at 20 percent, which may be lower than your ordinary marginal income tax rate. You must complete Part II of Form 4972 to choose this capital gain election.

As was the case for the 10-year averaging option, you can elect this treatment only once for any plan participant, and only if the plan participant was born before 1936. If you make the capital gain election, you can treat the remainder of the taxable distribution (i.e., the portion representing participation from 1974 to the present) either as ordinary income or under the 10-year averaging method. If you qualify to make a capital gain election but do not want to do so, you can treat the capital gain portion as ordinary income.

Tip: If you have an amount in box 6 of Form 1099-R, representing net unrealized appreciation, see below to figure the total amount subject to capital gain treatment.

How Do You Report Lump-Sum Distributions That Include Employer Securities?

If your lump-sum distribution includes employer securities (e.g., stock issued by the employer corporation), you may have to deal with net unrealized appreciation (NUA). NUA is the increase in the securities' value while they were in the qualified plan. More specifically, if the securities increased in value, the NUA consists of the fair market value of the securities at the time of the lump-sum distribution, minus their cost or basis when originally acquired by the qualified plan.

Generally, the NUA in employer securities received as part of a lump-sum distribution is tax deferred until you later sell or exchange the securities. When you dispose of the securities, any gain is treated as long-term capital gain up to the amount of the NUA. Any gain that is more than the NUA is either long-term or short-term capital gain, depending on how long you held the securities after the lump-sum distribution. If you don't want to defer the NUA, you can elect to include the NUA in your taxable income in the year you receive the lump-sum distribution. The amount of the NUA, if any, should be shown in box 6 of Form 1099-R. Part of the amount in box 6 will qualify for capital gain treatment if there is an amount in box 3 of Form 1099-R. Use the NUA Worksheet in the instructions to Form 4972 to determine the part that qualifies for capital gain treatment.

For more information about NUA, see IRS Publication 575.



This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


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Tags: Financial Planning, Lump Sum, Pension, Retirement Planning