What is it?
A lump-sum distribution is the withdrawal of the entire balance of an inherited traditional IRA or employer-sponsored retirement plan account in one tax year. It is this one-tax-year time frame, not the number of distributions, that determines a lump-sum distribution. A lump-sum distribution can take the form of a single distribution, or multiple distributions taken over the course of the tax year. This distribution option is generally available to you when you inherit a traditional IRA, and may be available to you when you inherit a retirement plan account (if the terms of the plan allow it). If you are not the sole primary beneficiary of the IRA or plan, the lump-sum distribution option will apply separately to your share of the inherited funds.
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As an IRA or retirement plan beneficiary, you will generally be subject to federal (and possibly state) income tax on a lump-sum distribution for the tax year in which it is taken (to the extent that the distribution represents pretax or tax-deductible contributions, and investment earnings). For this and other reasons, a lump-sum distribution is generally not regarded as the best way to distribute funds from an inherited IRA or plan. Other options for taking post-death distributions will typically provide more favorable tax treatment and other advantages.
Caution:
This discussion does not apply to Roth IRAs or Roth 401(k), 403(b), and 457(b) accounts. You can take a lump-sum distribution from an inherited Roth IRA, or an inherited Roth 401(k)/403(b)/457(b) account, but since qualified distributions from these plans are tax free (and nonqualified distributions are taxable only to the extent earnings are distributed), the considerations are quite different.
Requirements to take a lump-sum distribution
To be eligible to take a lump-sum distribution from a deceased IRA owner's or plan participant's account, you obviously must be a beneficiary of that account. Being a beneficiary of an IRA or retirement plan account generally means that you are designated by name as a primary beneficiary in the IRA or plan documents. You could also become a primary beneficiary of the IRA or plan if you are named as a secondary beneficiary (also known as a contingent beneficiary), and one or more of the original primary beneficiaries disclaims (i.e., refuses to accept) the inherited funds or predeceases the account owner.
In the case of a retirement plan account, you can only take a lump-sum distribution of the inherited funds if the plan offers this distribution option. Most plans do permit account beneficiaries to take lump-sum distributions, but you should check with the plan administrator to make certain.
Advantages of taking a lump-sum distribution
You receive all of the funds now
The main attraction of taking a lump-sum distribution from an inherited IRA or retirement plan is that you receive a sum of money in one tax year to use for your own benefit. The amount that you ultimately receive could be substantial depending on the size of the account, your share of the funds, and the portion that is lost to taxes. Once the funds are distributed to you, you generally have complete discretion over their use. You could use the money to pay your medical bills, finance your children's education, or fund the down payment on a home, or for any other purpose.
Special tax treatment may be available
With inherited retirement plan accounts, another potential advantage of taking a lump-sum distribution is that such distributions may be eligible for special income averaging treatment (if you were born before 1936). This can reduce the income tax liability on the inherited funds, but the availability of this special treatment is limited. In addition, special capital gains rules may apply to a portion of a lump-sum distribution attributable to pre-1974 plan participation. Special rules may apply to lump-sum distributions that include employer securities.
In many cases, the drawbacks of taking a lump-sum distribution from an inherited IRA or retirement plan will outweigh the perceived advantages.
Disadvantages of taking a lump-sum distribution
There may be adverse income tax consequences
As noted, when you take a lump-sum distribution of your inherited IRA or plan funds, you receive all of the funds in one tax year. This distribution must be reported as taxable income on your federal income tax return for that year. (If there were ever nondeductible or after-tax contributions made to the account, a portion of the distribution would not be taxable.) Depending on the size of the distribution and your federal income tax bracket, the portion of the funds that is lost to taxes may be substantial. This may be especially true if the distribution pushes you into a higher income tax bracket, causing the funds to be taxed at a higher rate.
Caution:
To make matters worse, your lump-sum distribution may be subject to state income tax as well as federal income tax. You should check the laws of your state for information regarding the tax treatment of IRA and retirement plan distributions.
If you want to minimize income taxes on the inherited IRA or plan funds, a lump-sum distribution is probably not the appropriate distribution option. Other methods of taking post-death distributions from the IRA or plan may be available, and will typically provide more favorable tax treatment.
The distributed funds will miss out on tax-deferred growth opportunities
Another major drawback to taking a lump-sum distribution from an inherited IRA or retirement plan is the loss of tax-deferred growth opportunities. When you take a lump-sum distribution, you are removing all of the IRA or plan funds from a tax-deferred environment. You may take the money from a lump-sum distribution (what is left of it after taxes) and invest it elsewhere, but the earnings will generally be subject to tax. Even if you immediately reinvest your lump-sum distribution in another tax-deferred vehicle, such as an annuity, you will still have to pay tax on the distribution itself.
How to take a lump-sum distribution
•Contact the plan administrator to confirm that a lump-sum distribution is an option.
•Consult a professional advisor: Before taking a lump-sum distribution from an inherited IRA or plan, speak to a tax advisor or other professional regarding your distribution options and the tax and estate planning considerations. Your advisor should be able to tell you whether a lump-sum distribution is appropriate in your case. In many cases, it will not be.
•Contact the IRA custodian or plan administrator: If you decide to take a lump-sum distribution, you will need to contact the IRA custodian or the plan administrator to request the necessary form for withdrawal. Return the form along with any necessary documentation (such as personal identification and/or a death certificate), indicating that you want to receive a lump-sum distribution.
•Report the distribution on your tax return: You must enter the taxable amount of your lump-sum distribution on your federal income tax return for the year of the distribution. Remember, not all of the distribution will be taxable if part of it represents nondeductible or after-tax contributions. Determine whether special averaging or other special tax treatment is available.
The information contained in this Higgins Capital communication is provided for information purposes and is not a solicitation or offer to buy or sell any securities or related financial instruments in any jurisdiction. Past performance does not guarantee future results.
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Ray Higgins San Diego broadridgeadvisor