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Pay now or roll over? Choose wisely to sleep easy

If you receive a distribution from a qualified retirement plan, such as a 401(k), you need to consider whether to pay taxes now or to roll over the account to another tax-deferred plan.
 
 Charles
Sims Jr.

If you receive a distribution from a qualified retirement plan, such as a 401(k), you need to consider whether to pay taxes now or to roll over the account to another tax-deferred plan. A correctly implemented rollover can avoid current taxes and allow the funds to continue accumulating tax deferred.

If you decide to take a lump-sum distribution, income taxes are due on the total amount of the distribution and are due in the year in which you cash out. Employers are required to withhold 20 percent automatically from the check and apply it toward federal income taxes, so you will receive only 80 percent of your total vested value in the plan.

The advantage of a lump-sum distribution is that you can spend or invest the balance as you wish. The problem with this approach is parting with all those tax dollars. Income taxes on the total distribution are taxed at your marginal income tax rate. If the distribution is large, it could easily move you into a higher tax bracket.

And distributions taken prior to age 59½ are subject to an additional 10 percent federal income tax penalty.

If you were born prior to 1936, there are two special options that can help reduce your tax burden on a lump sum.

The first special option, 10-year averaging, enables you to treat the distribution as if it were received in equal installments over a 10-year period. You then calculate your tax liability using the 1986 tax tables for a single filer.

The second option, capital gains tax treatment, allows you to have the pre-1974 portion of your distribution taxed at a flat rate of 20 percent. The balance can be taxed under 10-year averaging, if you qualify.

To qualify for either of these special options, you must have participated in the retirement plan for at least five years and you must be receiving a total distribution of your retirement account.

Note that these special tax treatments are one-time propositions for those born prior to 1936. Once you elect to use a special option, future distributions will be subject to ordinary income taxes.

(Charles Sims Jr., CFP, is President/ CEO of The Sims Financial Group. Contact him at 901- 682- 2410 or visit www.SimsFinancialGroup.com. The information in this article is not intended to be tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor.)

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