7.2 Lump-Sum Distributions

If you are entitled to a lump-sum distribution from a qualified company retirement plan or self-employed Keogh plan, you may avoid current tax by asking your employer to make a direct rollover of your account to an IRA or another qualified employer plan. If the distribution is made to you, 20% will be withheld, but it is still possible to make a tax-free rollover within 60 days (7.7).

If you receive a lump sum and do not make a rollover, the taxable part of the distribution (shown in Box 2a of Form 1099-R) must be reported as ordinary pension income on your return unless you were born before January 2, 1936, and qualify for special averaging, as discussed below. Your after-tax contributions and any net unrealized appreciation (NUA (7.10)) in employer securities that are included in the lump sum are recovered tax free; they are not part of the taxable distribution.

A taxable distribution before age 59½ is subject to a 10% penalty in addition to regular income tax, unless you qualify for an exception (7.15).

Lump-sum distribution defined.

A lump-sum distribution is the payment within a single taxable year of a plan participant’s entire balance from an employer’s qualified plan. If the employer has more than one qualified plan of the same kind (profit-sharing, pension, stock bonus), you must receive the balance from all of them within the same year. A series of payments may qualify as a lump-sum distribution provided you receive them within the same tax year. The account balance does not include deductible voluntary contributions you made after 1981 and before 1987; these are not eligible for lump-sum distribution treatment.

Plan participant must be born before January 2, 1936 for 10-year averaging or capital gain election.

If you were born before January 2, 1936, and receive a qualified lump-sum distribution (defined above) from your employer’s plan, you generally may elect to figure your tax on the distribution using the 10-year averaging method. The law technically requires that you be born before 1936, but a favorable IRS rule treats you as born before 1936 if you were born on January 1, 1936. If you participated in the plan before 1974, you may elect to apply a 20% rate to the pre-1974 part of the lump-sum distribution if 20% is lower than the averaging rate.

However, averaging and capital gain treatment are not allowed for a lump-sum distribution if any of the following are true: (1) you rolled over any part of the lump-sum distribution to an IRA or an employer qualified plan, (2) you received the distribution during the first five years that you participated in the plan, (3) you previously received a distribution from the same plan and you rolled it over tax free to an IRA or another qualified employer plan, (4) you elected 10-year or five-year averaging or capital gain treatment for any other lump-sum distribution after 1986, (5) after 2001 you rolled over to the same plan a distribution from a traditional IRA (other than a conduit IRA (7.3)), a 403(b) plan (7.21), or a governmental 457 plan (7.22), or (6) after 2001 you rolled over to the same plan a distribution that you received as a surviving spouse from the qualified plan of your deceased spouse.

Caution

Prior Rollover Bars Averaging

You may not claim averaging for a lump-sum distribution if you previously received a distribution from the same plan that was rolled over tax free (7.7) to an IRA or to another qualified employer plan.

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See the details on electing averaging (7.4) and the 20% capital gain rate (7.5).

If you are the beneficiary of a deceased plan participant, the participant’s age, not yours, determines your right to claim averaging, and the five-year participation rule does not apply; see 7.6.

Spousal consent to lump-sum distribution.

If you are married, you may have to obtain your spouse’s consent to elect a lump-sum distribution (7.11).

Withholding tax.

An employer must withhold a 20% tax from a lump-sum distribution that is paid to you and not rolled over directly by the employer to a traditional IRA or another employer plan (7.7).

Beneficiaries.

If you are the surviving spouse of a deceased plan participant (employee or self-employed) and receive a lump-sum distribution from his or her account, you can roll over the distribution to another qualified employer plan or to your own IRA. If you are a nonspouse beneficiary of a lump-sum distribution, you may instruct the plan to make a direct trustee-to-trustee transfer to an IRA that must be treated as an inherited IRA (7.8).

If the deceased employee was born before January 2, 1936, any beneficiary may elect special averaging or capital gain treatment for a lump-sum distribution of the account, unless the distribution is disqualified as discussed above under “Requirements for 10-year averaging or capital gain election” (7.6).

Court ordered lump-sum distribution to a spouse or former spouse.

If you are the spouse or former spouse of an employee and you receive a distribution under a qualified domestic relations order (QDRO), you may be eligible for a tax-free rollover or, in some cases, special averaging treatment (7.12).