Guest Article
by Denise Lamaute
Employers of most pension plans are required to withhold a mandatory 20% of your lump sum retirement distribution when you leave their company. However, you can avoid this tax hit if you make a direct rollover of those funds to an IRA rollover account or another similar qualified plan. Failure to rollover the entire amount of your lump sum distribution may result in your paying unnecessary taxes on all or a portion of your retirement payout.
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment similar to the federal income taxes withheld from your pay check. It is held by the federal government as a credit toward you r tax liability for the year in which your payout was made. You can use that tax prepayment to reduce your tax liability when you file your tax return the following year, usually by April 15th. Or, if you over paid your federal taxes you will be entitled to a refund of the excess taxes withheld.
To avoid the tax hit completely on your lump sum retirement distribution, it is advisable that you contact your investment representative, banker or new employer's retirement administrator before you agree to receive your pension distribution. Establish a rollover IRA account with your investment broker or banker. My firm has established rollover accounts for several individuals. Next, instruct your pension administrator of the company that you are leaving or have left to transfer your lump sum distribution directly to your new IRA rollover account or qualified plan.
When your lump sum retirement distribution is transferred directly from one trustee to another trustee without your ever taking possession of any portion of those funds, you avoid that 20% tax withholding hit. With a direct rollover, your pension funds escape being taxed until some time in the future when you begin to withdraw from that rollover account.
Caution: should you receive a check and it is for only 80% of your retirement funds, you may wind up paying taxes if you do not take some immediate and decisive action.
How severe will that tax bite be if a entire rollover is not carried out? For any portion of your lump sum retirement distribution that is not rolled over within 60 days of receiving your retirement check, you can expect to pay taxes at your tax bracket rate. What's more, if you are under age 59 1/2 at the time you receive your retirement distribution, you will be hit with an additional tax penalty equal to 10% of any amount not rolled over within the required 60 day period. For someone truly concerned about reducing their tax bite and putting their pension funds to work prudently, a botched rollover can be costly.
For example, if you were due to receive a $100,000 lump sum distribution and your former employer withheld $20,000, you'd pay $7,600 (38% tax bracket) in taxes. If you are younger than 59 1/2, you'll be hit with an additional 10% tax penalty equal to $2,000. Your tax bill on your $20,000 will then be $9,600 versus "0" with a complete rollover.
How do you achieve a tax-free rollover when you received only 80% of your funds and you need to rollover 100% of the distribution? Well, the answer is, you must find the 20% withheld amount from some other source. In essence, the funds you rollover must equal 100% of the retirement funds paid out on your behalf. The source of that "missing" 20%, for rollover purposes, is not important so long as you place 100% of your lump sum retirement distribution amount in a rollover account within 60 days of your receiving your distribution check.
Of course, a direct rollover is the easiest method to avoid taxation on your entire lump sum retirement distribution. But, should you find yourself facing a tax bite on your funds because you are unable to rollover the entire distributed amount, try to reduce that tax bite as much as possible. At least rollover the 80% portion of your lump sum retirement distribution. Next, attempt to rollover some portion of the withheld 20%.
The key to a tax-free pension rollover is to keep your pension distribution intact in a rollover account until you reach age 59 1/2. Or, should you absolutely need to tap into your pension funds before then, do so sparingly and wisely.
Denise Lamaute, pension tax attorney and investment banker with Lamaute Capital, Inc.
8383 Wilshire Blvd.
Suite 840
Beverly Hills, CA
213-655-1560,
FAX: 213-655-8319
e-mail: [email protected]
BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisem*nts published on this Web site, including the article shown above.
FAQs
To avoid the tax hit completely on your lump sum retirement distribution, it is advisable that you contact your investment representative, banker or new employer's retirement administrator before you agree to receive your pension distribution. Establish a rollover IRA account with your investment broker or banker.
How to avoid taxes on pension income? ›
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.
Do I pay taxes when I take money out of my pension? ›
Taxes on Pension Income
You may owe federal income tax at your regular rate as you receive the money from pension annuities and periodic pension payments. But if you take a direct lump-sum payout from your pension instead, you must pay the total tax due when you file your return for the year you receive the money.
How much of pension distribution is taxable? ›
Funds distributed directly to the taxpayer are generally subject to a 20% federal income tax withholding.
How do I avoid taxes on retirement withdrawals? ›
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.
How much federal tax is taken out of a pension check? ›
The 20% withheld from your lump sum retirement distribution is a federal income tax prepayment similar to the federal income taxes withheld from your pay check. It is held by the federal government as a credit toward you r tax liability for the year in which your payout was made.
At what age do you stop paying taxes on your pension? ›
Taxes aren't determined by age, so you will never age out of paying taxes. Basically, if you're 65 or older, you have to file a tax return in 2022 if your gross income is $14,700 or higher. If you're married filing jointly and both 65 or older, that amount is $28,700.
Do pensions count as earned income? ›
Minimum retirement age generally is the earliest age at which you could have received a pension or annuity if you were not disabled. Beginning on the day after you reach minimum retirement age, payments you receive are taxable as a pension and are not considered earned income.
What is the 20% withholding rule? ›
A payer must withhold 20% of an eligible rollover distribution unless the payee elected to have the distribution paid in a direct rollover to an eligible retirement plan, including an IRA.
Can you roll a pension into an IRA without paying taxes? ›
You can avoid paying taxes on the rollover if your pension is going to a traditional IRA. You only pay taxes when you make a withdrawal if the withdrawal is going to the traditional IRA. This is different for a Roth IRA. If you set up a Roth IRA, you pay taxes when the pension is rolled over.
Unless you contributed to your pension, the entirety of your pension income will be taxable at your regular income tax rate. In other words, if your pension income all comes from money your employer contributed, with no additional contributions on your part, it's all fully taxable.
Which state doesn't tax pensions? ›
Eight of them – Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming – don't tax wages, salaries, dividends, interest or any sort of income. New Hampshire, the ninth state, has no state income tax on wages, salaries, retirement account withdrawals or pension payments.
What retirement distributions are tax-free? ›
Roth IRA or Roth 401(k) qualified distributions are tax-free.
What is the best order to withdraw money in retirement? ›
There are several approaches you can take. A traditional approach is to withdraw first from taxable accounts, then tax-deferred accounts, and finally Roth accounts where withdrawals are tax free. The goal is to allow tax-deferred assets the opportunity to grow over more time.
How can I make my retirement withdrawals more tax efficient? ›
Proportional withdrawal strategy.
This strategy draws proportionally from taxable accounts and tax-deferred accounts first, then from Roth accounts. Withdrawals are taken proportionally from taxable and tax-deferred accounts based on the account balance at the time of the withdrawal.
How can I withdraw money from my retirement account without taxes? ›
The easiest way to borrow from your 401(k) without owing any taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer's 401(k) plan into one sponsored by your new employer.
How do I withhold taxes from my pension? ›
A payee can ask the payer to withhold at any rate (from 0% to 100%) using Form W-4R, Withholding Certificate for Nonperiodic Payments and Eligible Rollover Distributions.
How can I generate tax-free income in retirement? ›
6 Ways To Get More Tax-Free Income In Retirement
- Here Are 6 Tax Planning Strategies To Get More Tax-Free Income.
- Contribute To Your Roth IRA.
- Set Up Your Roth 401(k) Or Roth 403(b) Now.
- Mega Backdoor Roth Contributions.
- Tax-Free Income From Municipal Bonds And Funds.
- Optimize Your Health Savings Account For Tax-Free Income.
