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Lump-Sum Distributions

A lump-sum distribution is the distribution (or payment) within a single tax year, of an employee's entire balance from the employer's qualified pension plans, qualified stock bonus plans, or qualified profit-sharing plans. If the employee has more than one account in any of these categories, all funds must be distributed. Further, the distribution must have been made under one of the following four conditions:

  1. Because the employee died,
  2. After the employee reached age 59 ½,
  3. Because the employee separated from the service of the employer, or
  4. Because a self-employed individual became totally and permanently disabled.

A lump-sum distribution may qualify for special tax treatment that includes the 5 year or 10 year tax option, as well as the 20% capital gain treatment. These optional methods can be elected only once after 1986 for any plan participant. (More onformation on the 5 year option can be found in Publication 575, Pension and Annuity Income, and in the instructions for Form 4972, Tax on Lump-Sum Distributions.

The recipient of a lump-sum distribution may choose the 5 or 10 year option to figure the tax on the ordinary part of the distribution. Note: the 5 year option is available for only those distributions made before January 1, 2000. The 20% capital gain election can be made to compute the tax on the taxable portion of the distribution that applies to the portion received for participating in the plan before 1974. Those choices allow taxpayers who have reached age 50 before 1986 (born before 1936) to have the pre-1974 taxable portion taxed at a 20% rate, while the remainder of the distribution, including the portion for all post-1973 participation, is taxed as ordinary income.

401k Fact-
Defined Contribution Plans, also known as individual account plans, defined contribution plans specify the amount of funds placed in a participant's account (for example, 10 percent of salary). The amount of funds accumulated and the investment gains or losses solely determine the benefit received at retirement. The employer bears no responsibility for investment returns, although the employer does bear a fiduciary responsibility to select or offer a choice of sound investment options. There are several basic types of defined contribution plans, including simplified employee pension plans, profit sharing plans, money purchase plans, 401(k) and profit sharing plans---Target Labs (www.targetlab.com) setup a 401k, and this small company is very pleased with its reception company-wide.

You should receive Form 1099-R from your employer showing your taxable distribution and the amount eligible for capital gain treatment. If you do not receive this form by February 1, 1999, you should contact the payer of the lump-sum distribution.

You may choose to postpone paying tax on all or part of your lump-sum distribution by requesting your employer to directly roll over the taxable portion into an Individual Retirement Arrangement (IRA). You can also postpone the tax on a lump-sum distribution paid to you by rolling over the taxable amount yourself into an IRA within 60 days after the distribution. Select Topic 413 for information on rollovers. RRP

Mandatory income tax withholding of 20% applies to most taxable distributions paid to you in a lump sum from employer pension plans, regardless of whether or not you roll it over in 60 days.

Lump-Sum Distributions

If you receive a lump-sum distribution from a qualified retirement plan, you may be able to elect optional methods of figuring the tax on the distribution. The part from active participation in the plan before 1974 may qualify for capital gain treatment. The part from participation after 1973 (and any part from participation before 1974 that you do not report as capital gain) is ordinary income. You may be able to use the 5- or 10-year tax option, discussed later, to figure tax on the ordinary income part.

You can use these tax options to figure your tax on a lump-sum distribution only if the plan participant was born before 1936.

You may be able to figure the tax on a lump-sum distribution under the 5-year tax option even if the plan participant was born after 1935. You can choose this option for tax years beginning before the year 2000 only if the distribution is made on or after the date the participant reached age 59 1/2 and the distribution otherwise qualifies.

For tax years beginning after 1999, the 5-year tax option for figuring the tax on lump-sum distributions from a qualified retirement plan is repealed. However, a plan participant can continue to choose the 10-year tax option or the capital gain treatment for a lump-sum distribution that qualifies for the special treatment.

Lump-sum distribution defined. A lump-sum distribution is the distribution or payment of a plan participant's entire balance (within a single tax year) from all of the employer's qualified plans of one kind (pension, profit-sharing, or stock bonus plans). The participant's entire balance does not include deductible voluntary employee contributions or certain forfeited amounts.

The distribution is paid:

  1. Because of the plan participant's death,
  2. After the participant reaches age 59 1/2,
  3. Because the participant, if an employee, separates from service, or
  4. After the participant, if a self-employed individual, becomes totally and permanently disabled.

Reemployment. A separated employee's vested percentage in his or her retirement benefit may increase if he or she is rehired by the employer. This possibility does not prevent the distribution from qualifying as a lump-sum distribution. However, if an employee's vested percentage in benefits previously subject to lump-sum treatment increases after reemployment, the employee must recapture the tax saved by applying lump-sum treatment as provided by Treasury regulations.

Alternate payee under qualified domestic relations order. If you receive a distribution as an alternate payee under a qualified domestic relations order (discussed earlier under General Information), you may be able to choose the optional tax computations for it. You can make this choice for a distribution that would be treated as a lump-sum distribution had it been received by your spouse or former spouse (the plan participant). However, for this purpose, the balance to your credit does not include any amount payable to the plan participant.

More than one recipient. One or all of the recipients of a lump-sum distribution can use the optional tax computations. See Multiple Recipients of a Lump-Sum Distribution in the instructions for Form 4972.

Distributions that do not qualify. The following distributions do not qualify as lump-sum distributions.

  1. A distribution of your deductible voluntary employee contributions and any net earnings on these contributions. A deductible voluntary employee contribution is a contribution that:
    1. Was made by the employee in a tax year beginning after 1981 and before 1987 to a qualified employer plan or a government plan that allows such contributions,
    2. Was not designated by the employee as nondeductible, and
    3. Was not mandatory.
  2. U.S. Retirement Plan Bonds distributed with a lump sum.
  3. Any distribution made during the first 5 tax years that the employee was a participant in the plan, unless it was made because the employee died.
  4. The current actuarial value of an annuity contract included in a lump-sum distribution. (However, this value is used to figure tax on the ordinary income part of the distribution under the 5- or 10-year tax option method.)
  5. A distribution to a 5% owner that is subject to a penalty because it exceeds the benefits provided under the plan formula.
  6. A distribution from an IRA.
  7. A distribution of the redemption proceeds of bonds rolled over tax free to the plan from a qualified bond purchase plan.
  8. A distribution from a qualified plan if the plan participant or his or her surviving spouse previously received an eligible rollover distribution from the same plan (or another plan of the employer that must be combined with that plan for the lump-sum distribution rules) and the previous distribution was rolled over tax free to another qualified plan or to an IRA.
  9. A corrective distribution of excess deferrals, excess contributions, excess aggregate contributions, or excess annual additions.
  10. A lump-sum credit or payment from the Federal Civil Service Retirement System (or the Federal Employees Retirement System).
  11. A distribution from a tax-sheltered annuity.
  12. A distribution from a qualified plan if any part of the distribution is rolled over tax free to another qualified plan or IRA.
  13. A distribution from a privately purchased commercial annuity.
  14. A distribution from a section 457 deferred compensation plan of a state or local government or a tax-exempt organization.

How to treat the distribution. If you receive a lump-sum distribution from a qualified retirement plan, you may have various options for how you treat the taxable part. You can:

  1. Roll over all or part of the distribution. No tax is currently due on the part rolled over. See Rollovers, later.
  2. Report the entire taxable part of the distribution as ordinary income on your tax return.
  3. Report the part of the distribution from participation before 1974 as a capital gain and the amount from participation after 1973 as ordinary income (if you qualify).
  4. Use the 5- or 10-year tax option, discussed later, to figure the tax on the ordinary income part of the distribution (from participation after 1973) if you qualify. Report the capital gain part (from participation before 1974) on Form 4972, Part II (if you qualify).
  5. Use the 5- or 10-year tax option to figure the tax on the total taxable amount (if you qualify).

These various options are explained in the following discussions.

Electing optional lump-sum treatment. You can choose to use the 5- or 10-year tax option or capital gain treatment only once after 1986 for any plan participant. If you make this choice, you cannot use any of these optional methods for any future distributions for the participant.

Complete Form 4972 and attach it to your Form 1040 income tax return if you want to use the tax options. If you received more than one lump-sum distribution for a plan participant during the year, you must add them together in your computation.

If you and your spouse are filing a joint return and you both have received a lump-sum distribution, each of you should complete a separate Form 4972. Then add the separate taxes from the Forms 4972 and enter the total on line 40, Form 1040.

Time for choosing. You must decide to use the tax options before the end of the time, including extensions, for making a claim for credit or refund of tax. This is usually 3 years after the date the return was filed or 2 years after the date the tax was paid, whichever is later. (Returns filed before April 15 are considered filed on April 15.)

Changing your mind. You can change your mind and decide not to use the tax options within the time period just discussed. If you change your mind, file Form 1040X, Amended U.S. Individual Income Tax Return, with a statement saying you do not want to use the optional lump-sum treatment. You must pay any additional taxes due to the change with the Form 1040X.

Taxable and tax-free parts of the distribution. You may recover your cost in the lump sum tax free. In general, your cost consists of:

  1. The plan participant's total nondeductible contributions to the plan,
  2. The total of the plan participant's taxable costs of any life insurance contract distributed,
  3. Any employer contributions that were taxable to the plan participant,
  4. Repayments of loans that were taxable to the plan participant,
  5. The net unrealized appreciation in employer's securities distributed, and
  6. The death benefit exclusion, only if you are the beneficiary of a deceased employee who died before August 21, 1996. See Death benefit exclusion under Investment in the Contract (Cost), earlier.
You must reduce this cost by amounts previously distributed tax free.

The total taxable amount of a lump-sum distribution is the part that is the employer's contribution and income earned on your account.

Losses. You may be able to take a loss on your return if you receive a lump-sum distribution that is less than the plan participant's cost in the lump-sum. You must receive the distribution entirely in cash.

To claim the loss, you must itemize deductions on Schedule A (Form 1040). Show the loss as a miscellaneous deduction (subject to the 2%-of-adjusted- gross-income limit). The amount that you may claim as a loss is the difference between the participant's cost and the amount of the distribution.

Distributions of employer securities. If your distribution includes securities in the employer's corporation, these securities may have increased in value while they were in the trust. "Securities" includes stocks, bonds, registered debentures, and debentures with interest coupons attached. This increase in value is called "net unrealized appreciation" (NUA).

If the distribution is a lump sum, you are not taxed on the NUA when you get the securities, unless you elect to include it in your gross income in the year received.

If the distribution is not a lump sum, this tax deferral applies only to the extent the NUA in employer securities results from employee contributions. This treatment does not apply to a distribution based on deductible voluntary employee contributions (defined earlier). The NUA on which tax is deferred should be shown in box 6 of the Form 1099-R you receive from the payer of the distribution.  

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.privatelabel401k.com and www.mutualfunds401k.com 

You can choose to be taxed on the NUA before you sell the securities. Make this choice on the tax return on which you have to include the distribution. If you choose to be taxed on the NUA and there is an amount in box 3 of the Form 1099-R, part of the NUA will qualify for capital gain treatment. See the instructions for Form 4972.

When you sell or exchange employer securities with untaxed NUA, any gain is long-term capital gain up to the amount of the NUA. Any gain that is more than the NUA is a long-term or short-term capital gain, depending on how long you held the securities after the distribution. RRP

 

 

 

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