The Lump Sum
You're there. The magic day has arrived. The desk has been cleared, all personal mementos have been carted home, and you have received the proverbial gold watch. All that's left is to get with Catbert, the Evil Personnel Director, to tie up some remaining loose ends, and then you're out the door forever. Goodbye, drudgery! Aloha, Mai Tais. (No, we don't mean to paint quite such a disturbing picture of the Hades of job hatred followed by the Nirvana of fruity alcohol, but what the heck.) Here you come! Congratulations, Fool. You're about to grab the brass ring!
Catbert smiles sardonically as you enter his office and says, "We just need you to fill out a few forms, Josh, and you'll be on your way. Tell us how you want to take your money, sign this irrevocable option form, and you're outta here. You've got to make the choice on your own, though. I can't advise you at all. You know why: liability issues, fiduciary responsibilities, lawyers, etc. But you're a bright guy. After all, you managed to last a whole career here, didn't you? You'll figure it out. Just tell me how you want to handle your distribution in the next five minutes, though, okay? I'm a busy guy and can't spend all day chewing the fat with ex-employees."
Making that choice is a piece of cake isn't it, Josh? Just grab the money and run, right? It isn't often that you see six-or-seven figure sums staring you in the face, and it's all yours, Fool. Snatch that check, deposit it in your bank, and board that cruise liner to luxury land. You can work out the nitty-gritty with your tax advisor at the end of the year. Right now your better half is waiting with luggage in hand and the camera slung over her shoulder. Get a move on, guy, 'cause time's a-wasting!
Uh, Josh? Don't be too hasty, or you may be in for a very rude awakening. This choice is a one-time decision. Go the wrong way now, and you could very well lose about half of the money you've accumulated through your working career. The taxman would steal it away while you weren't looking. This decision is not one that can be ignored or left to the last minute. You must know all of your options, and you must know the tax impact of each choice. Without that knowledge, it's too easy to make a mistake that could haunt you for the rest of your life.
For most of us, the sums that become available at retirement are the largest amounts of money that we will control in our entire lives. The decision on how we handle that money is probably the most important one we will make, as well. Knowing that, Fools believe this is one of the times in our lives when it makes sense to consult the experts. In this case, about six months prior to retirement we would see a skilled tax practitioner who's experienced in retirement plan distributions. We would have that expert run the various scenarios for us to see the potential results. Then, armed with that knowledge, we would choose the option that best fits our personal situation. How much would that cost? Anywhere from $200 to $750 is a good guess. Measure that against a possibly huge loss from your retirement stash, and most Fools would agree the advice is well worth the cost.
Generally, normally, usually (truly! madly! deeply!), the best choice for a retirement plan distribution is to transfer that money to an Individual Retirement Account. By doing so, the tax-deferred status of that sum continues and we reduce our current tax burden. Be aware, though, an IRA is not always the right choice, which is another reason to seek expert tax advice regarding these distributions. Once the money is in the IRA, it is subject to IRA rules. That's no problem when a person is older than 59 ½. We're free to withdraw as much money as we want at any time, and we will only pay ordinary income taxes on that sum. But what if you retire at a younger age?
Retire at age 55 or older, but younger than age 59 ½, and two factors come into play. At age 55, you may retire and receive qualified retirement plan proceeds without penalty. You will pay ordinary income taxes on any sum you keep. Put that money in an IRA, though, and now you must play by those rules. Take money out of the IRA, and you'll pay ordinary taxes plus a 10% early withdrawal penalty because you are under age 59 ½. Bummer! You don't want to pay taxes all at once on your retirement plan money. You want the tax deferral of the IRA. You don't want to pay that lousy 10% penalty on IRA withdrawals. And you still need money to live on each year until you can get at the IRA. What do you do? Add another reason to go see the tax consultant, Fool. You have several options, but to choose one of them you need to know their ramifications. The expert can outline them for you.
You could keep just enough money from your retirement plan to live on until you reach age 59 ½, and transfer the rest to the IRA. You'd have to pay taxes on the sum you keep, though. You could transfer all the money to the IRA and then make withdrawals under Section 72(t) of the Internal Revenue Code. That's an exception that allows you to avoid the 10% penalty. But do that and you have to live with the income the computations produce, which may not be enough cash. Further, you have to take that income for the longer of five years or until you reach age 59 ½. Therefore, once started, you can't stop at will. What's the best choice? Ask your tax consultant.
Alrighty! You've seen the consultant, and you've made your choices. What's next? Step 11, How to leave the leftovers to your heirs.