What would you do with a lump sum payout?

[bookkeeper]

My DH is eligible to retire next year.  He has his choice of a pension or a lump sum distribution.  He also has a 401k.  We did a good job saving in our tax deferred accounts, but not such a great job saving money in taxable accounts.

Our year end will look like this:

Value of lump sum distribution amount        1,500,000
(will be available on 8-15-2014)

Value of 401k                                               500,000

Value of Roth IRA (both spouses)                     65,000

Value of Deferred Compensation                    112,000

No one is pushing him out the door, but he doesn't want to work much longer.  He will be 55 years old upon his separation.  I am age 50 and no longer working.  The pension is not adjusted for COLA, so we lean toward taking the lump sum.

We live simply.  We only have mortgage debt remaining, and that will be around $60,000 next August.  We own a vacation home free and clear.  We would relocate to South Dakota where there is no state income tax.  The deferred compensation must be distributed upon his separation.

With some quick calculations, if we do nothing else, our tax bill would be $5200 on $60,000 of income, $8200 on $80,000 of income and $12180 on $100,000 of income from the lump sum.

I am trying to educate myself about the best way to go about distributions and the subsequent income tax due.

What would the Tax Talk posters do if they were in our shoes? 

[Peace77]

There are 7 states with no income tax: Alaska, Florida, Nevada, South Dakota, Texas, Wyoming, and Washington.  Have you lived in South Dakota before?  If not, you might want to visit it in winter before moving there.  Winters can be brutally COLD.

How do you figure 2 different income amounts? $60k and $80k.

People are living much longer now.  Your savings may need to last 50 years or more.   Just paying for healthcare expenses and insurance until Medicare kicks in can be quite expensive.   Perhaps your DH could do some different work such as consulting rather than quitting completely.

[bookkeeper]

We both grew up and lived in SD until almost age 40, so we are Ok with the weather.  We bought a second home in AZ for cheap when the housing bubble popped on the outskirts of Phoenix.  We plan to take advantage of the good weather in both locations.

We live pretty simply, and could use the next few years to really grow our nest egg if we cut way back on the expenses in our lives.  I was quoting the federal income tax bill for different annual income amounts.  We would be able to decide if we can live on 60, 80 or 100 thousand. 

We hope to split our time between states and it is fine with me to live modestly in SD for a few years.  Depending on where you live, housing can be very low cost in SD. 

My husband has been asked to do some consulting work upon retirement, we both could work more if we wanted to.

We are coming up on a life change in a few months and it is time to figure out how to best structure the retirement savings investments, income streams from those investments and the taxes we will owe after we make our choices.

[Peace77]

If you spend $100,000 each year for the next 50 years, that would total $5 million.  That does not account for income tax or interest/dividends earned.

Since it is becoming more common to live to age 100 and beyond, that must be taken into consideration.

Have you estimated the costs of running 2 homes, travel between them and healthcare costs post retirement?

[bookkeeper]

Healthcare ($15,000) and housing costs ($18,000) are figured into our retirement budget.  Travel between the two homes would be less than $2000/year.

I will inherit some farm ground in the next 10 years that will provide a cushion (and an annual income) in our lives, when it occurs.

We are currently living on about 40% of our income, so we do know how to budget.  Social security will add to our cushion. 

[The Captain]

You mention moving to a state that has no income taxes in retirement.  Is there any chance of establishing residency before you take the lump sum distribution to minimize the state income tax impact?

Every little bit helps. 

Also, based on the numbers you've provided I would highly recommend a meeting with a certified financial planner.

[bookkeeper]

Nov 22, 2013 13:13:24 GMT -5 The Captain said:

You mention moving to a state that has no income taxes in retirement.  Is there any chance of establishing residency before you take the lump sum distribution to minimize the state income tax impact?

Every little bit helps. 

Also, based on the numbers you've provided I would highly recommend a meeting with a certified financial planner.

We can establish residency at any point we wish.  That is a good point.  We will follow up with a CFP and an accountant because I want to work a plan, not plan to get worked over!

Have you ever worked with a Deferred Compensation?  We assume it will be handled like one big paycheck, with FICA, Federal Withholding and State Withholding all deducted before we get what is left.  I don't think residency will have any affect on our tax burden on the Deferred Compensation payout.  The state where the money was earned will get theirs, no doubt. 

[The Captain]

Nov 22, 2013 14:38:07 GMT -5 bookkeeper said:

Nov 22, 2013 13:13:24 GMT -5 The Captain said:

You mention moving to a state that has no income taxes in retirement.  Is there any chance of establishing residency before you take the lump sum distribution to minimize the state income tax impact?

Every little bit helps. 

Also, based on the numbers you've provided I would highly recommend a meeting with a certified financial planner.

We can establish residency at any point we wish.  That is a good point.  We will follow up with a CFP and an accountant because I want to work a plan, not plan to get worked over!

Have you ever worked with a Deferred Compensation?  We assume it will be handled like one big paycheck, with FICA, Federal Withholding and State Withholding all deducted before we get what is left.  I don't think residency will have any affect on our tax burden on the Deferred Compensation payout.  The state where the money was earned will get theirs, no doubt. 

Bookkeeper - I dabbled enough in deferred compensation to know it's a minefield. The rules vary state by state.

For example - in one east coast state (NJ I think) pensions are subject to income tax withholding and I believe it is based on where the earnings that generated the pension were earned. In other states the employers do not have to withhold from pension payments.  Most states require the employer to withhold, others may not depending on how the deferred compensation is structured.

My experience in the area is incomplete and out of date.  I do know the tax planning by shifting residency is still available in some cases, but wanted to advise you to get advice from someone more competent than I am .  To be honest, the numbers you posted justify consulting an expert is both your current residential state and the one to which you may relocate.

Good luck and enjoy that retirement!

[mwcpa]

Some good points are noted here...

With the deferred comp the state where the work was done is more than likely the state who will tax it... many states have "accrual" rules.... and some are more aggressive than others... NY requires that you post a bond or pay state tax on the full amount when you leave the state before you get paid....

Under federal laws qualified plan are only taxed to where you live, not where you earned the money that lead to the deferral.  So, if I worked in NY and made IRA contributions that were fully deductible under NY law and then "retired" and moved to Florida (giving up all connections to NY), NY could not tax the IRA withdrawals while I was a resident of Florida.

[phil5185]

You mention the Fed Tax on the $100,000 earnings from the $1.5M - but won't the $15M itself be taxed in the year that you receive it? Ie, maybe        >$200,000?   (If you took it as a pension it would be taxed, I would assume that the lump-sum method would be handled similarly?)

IMO, your plan sounds great, I would take the lump sum and invest it, use the return if needed to supplement living costs, and leave a little seed money so that the $1.5M keeps growing slightly.

As for picking one of the no-tax states, I wouldn't make that a decision point - or a deal-breaker.  It's nice - but actually, the 'tax-free' states make it up elsewhere - property tax, sales tax, usury tax, etc - it costs about so much to run a state govt, the money comes from somewhere.

[mwcpa]

good point Phil...

1.5 million of income in 2014 will be subjected partially to the 39.6% tax bracket....

[bookkeeper]

From what we have been told by the retirement counselors that work with this plan, the lump sum distribution from a qualified retirement plan will be rolled over directly into a traditional IRA.  We would then pay federal income tax on the amount we withdraw from the IRA annually, not the whole ball of wax at one time.

I have been reading about individuals with a traditional IRA who are paying the tax and moving their money into a Roth IRA to lower their taxable income going forward.  I don't know if this would be something we should look into while DH is still working.

Add to this the fact that we need to buy our health insurance once DH quits working and we have a new can of worms.  Our taxable income will have a part to play on how much we pay for health insurance.

[bookkeeper]

I was also considering a phone call to the department of labor in our state.  I would like to nail down just what the deferred compensation rules will be when DH retires and the account belongs to us.

The deferred compensation includes money the employer set aside into an investment account and the earnings it has generated the last 8 to 10 years.  My DH has control over the investment decisions with regard to this account, but does not have access to the money until separation.

[dancinmama]

Nov 25, 2013 10:45:28 GMT -5 bookkeeper said:

From what we have been told by the retirement counselors that work with this plan, the lump sum distribution from a qualified retirement plan will be rolled over directly into a traditional IRA.  We would then pay federal income tax on the amount we withdraw from the IRA annually, not the whole ball of wax at one time.

I have been reading about individuals with a traditional IRA who are paying the tax and moving their money into a Roth IRA to lower their taxable income going forward.  I don't know if this would be something we should look into while DH is still working.

Add to this the fact that we need to buy our health insurance once DH quits working and we have a new can of worms.  Our taxable income will have a part to play on how much we pay for health insurance.

I am certainly no tax expert, but I believe that any withdrawals you take from that IRA prior to age 59 1/2 will not only be subject to state and federal income tax, but also to the 10% early withdrawal penalty.  However, if your DH is 55 when he separates (retires) from his company, if he keeps the 401k in place (as opposed to rolling over into an IRA), he can withdraw from it penalty before the age of 59 1/2.

[dancinmama]

Nov 22, 2013 13:01:43 GMT -5 bookkeeper said:

Healthcare ($15,000) and housing costs ($18,000) are figured into our retirement budget.  Travel between the two homes would be less than $2000/year.

I will inherit some farm ground in the next 10 years that will provide a cushion (and an annual income) in our lives, when it occurs.

We are currently living on about 40% of our income, so we do know how to budget.  Social security will add to our cushion. 

I think planning for early retirement is awesome!!  You've saved a lot and earned a lot in pension funds/deferred compensation.

Since you have no taxable accounts, where has the other 60% been going?  I am thinking mortgage pay down and/or the Roth? 

How comfortable are you with making investment decisions?   If you opt out of the pension, your entire retirement will be riding on you and your investment choices.  How comfortable do you feel about that?   Have you read anything on the sequence of returns and how it can drastically effect retirement?  

Have you put pencil to paper, so to speak, with a retirement budget?  Have you test driven your retirement budget?  Do you know how much you spent on food last year? 

Have you actually plugged your numbers into a retirement calculator?  Retirement calculators are designed to give you a pretty good idea of whether or not you will outlive your money.

When I look at your retirement funds, I am a little concerned that you have only saved $65,000 that is tax-free and I'm thinking you will want to let that grow because it is in a Roth.    When you make withdrawals from any of your tax-deferred accounts you will not only need to withdraw the money you need to live off of, you will also have to withdraw the money needed to pay the tax on it.

It is good that you are here asking questions.  Since your DH does not HAVE TO retire, I would take as much time as you need to do some more homework playing with retirement budgets, retirement calculators, etc. before making any permanent decisions, even if it means he works a little longer.

There is a forum call FIRE (google early retirement forum) where you can get a lot of information on planning for early retirement.  I hope you find it very helpful.

Note:  My DH retired at age 56 after 33 years of service with the same company.  We did A LOT of number crunching before he actually pulled the trigger.  I feel every second spent was well worth it.

I hope you and your DH enjoy retirement.  I highly recommend it. 

[Ombud]

Nov 22, 2013 13:13:24 GMT -5 The Captain said:

Also, based on the numbers you've provided I would highly recommend a meeting with a certified financial planner.

DEFINITELY THAT!!

[bookkeeper]

Dancinmama thank you for responding. I was hoping to tap into some people who had experienced what we are planning to do.

To answer your questions.

1. the other 60% has been going into a Roth IRA, Roth 401k, deferred compensation, to the government in the form of payroll taxes, state and federal income taxes as well as paying down our mortgage and financing a kid in college (he will be done in May).

2.  We are fairly comfortable making investment decisions.  DH has managed the investments in the retirement funds up to this point.  We have spoken to one CFP and plan on seeing another one in March.  DH's retirement advisors put us through a very detailed questionnaire regarding income and expenses before providing us with different retirement scenarios.

3.  I do all the bill paying and savings forecasting for our family.  I know exactly how much we spend and have put together a retirement budget based on our current expenses.

4.  Retirement calculators, yes I have used a few.  The CFP had one too and there was no red on the screen.

5.  I realize we have too much of our savings in tax deferred accounts.  That is why we have changed all retirement savings over to Roth contributions this year.  I also have a tax free municipal bond fund account with around $60,000 in it.  That could provide some tax free income should we need to use it.

I would be interested to hear what worked and what didn't work for your family as you transitioned from work to retirement.

[bookkeeper]

Jan 6, 2014 9:40:23 GMT -5 dancinmama said:

Nov 25, 2013 10:45:28 GMT -5 bookkeeper said:

From what we have been told by the retirement counselors that work with this plan, the lump sum distribution from a qualified retirement plan will be rolled over directly into a traditional IRA.  We would then pay federal income tax on the amount we withdraw from the IRA annually, not the whole ball of wax at one time.

I have been reading about individuals with a traditional IRA who are paying the tax and moving their money into a Roth IRA to lower their taxable income going forward.  I don't know if this would be something we should look into while DH is still working.

Add to this the fact that we need to buy our health insurance once DH quits working and we have a new can of worms.  Our taxable income will have a part to play on how much we pay for health insurance.

I am certainly no tax expert, but I believe that any withdrawals you take from that IRA prior to age 59 1/2 will not only be subject to state and federal income tax, but also to the 10% early withdrawal penalty.  However, if your DH is 55 when he separates (retires) from his company, if he keeps the 401k in place (as opposed to rolling over into an IRA), he can withdraw from it penalty before the age of 59 1/2.

Since DH will be 55 years of age and has 30 years of service with the company, he will be eligible for a 72T exemption for all retirement withdrawals.  He is planning on keeping the 401k and investing the lump sum amount separately.

[dancinmama]

Jan 6, 2014 14:26:02 GMT -5 bookkeeper said:

Jan 6, 2014 9:40:23 GMT -5 dancinmama said:

I am certainly no tax expert, but I believe that any withdrawals you take from that IRA prior to age 59 1/2 will not only be subject to state and federal income tax, but also to the 10% early withdrawal penalty.  However, if your DH is 55 when he separates (retires) from his company, if he keeps the 401k in place (as opposed to rolling over into an IRA), he can withdraw from it penalty before the age of 59 1/2.

Since DH will be 55 years of age and has 30 years of service with the company, he will be eligible for a 72T exemption for all retirement withdrawals.  He is planning on keeping the 401k and investing the lump sum amount separately.

Oh yes, you're right about the 72T exclusion (we're not taking advantage of it so it slipped my mind), but I believe that the amount that you can or have to withdraw annually is determined by the government and is adjusted annually based on gain/losses in the account.  You avoid the 10% penalty, but you pay for it in letting the government determine how much will be withdrawn and therefore what tax bracket that puts you in.

Age/Yrs of service is not related to eligibility to do a 72T;  anyone can do it.

Again, best of luck in your DH's upcoming retirement!! 

[bookkeeper]

We have been told by the retirement professionals at DH's company that we can determine the amount we want to draw from the retirement accounts, not the government, because DH does meet the 55 years of age and 30 years of participating in the same retirement plan. We will revisit this in March when we have another sit down appointment with the retirement specialists.

DH is getting really burnt out at his job.  He has finally allowed himself to start looking forward to the end.  One end and one beginning.

[dancinmama]

Jan 6, 2014 14:23:41 GMT -5 bookkeeper said:

Dancinmama thank you for responding. I was hoping to tap into some people who had experienced what we are planning to do.

To answer your questions.

1. the other 60% has been going into a Roth IRA, Roth 401k, deferred compensation, to the government in the form of payroll taxes, state and federal income taxes as well as paying down our mortgage and financing a kid in college (he will be done in May).

2.  We are fairly comfortable making investment decisions.  DH has managed the investments in the retirement funds up to this point.  We have spoken to one CFP and plan on seeing another one in March.  DH's retirement advisors put us through a very detailed questionnaire regarding income and expenses before providing us with different retirement scenarios.

3.  I do all the bill paying and savings forecasting for our family.  I know exactly how much we spend and have put together a retirement budget based on our current expenses.

4.  Retirement calculators, yes I have used a few.  The CFP had one too and there was no red on the screen.

5.  I realize we have too much of our savings in tax deferred accounts.  That is why we have changed all retirement savings over to Roth contributions this year.  I also have a tax free municipal bond fund account with around $60,000 in it.  That could provide some tax free income should we need to use it.

I would be interested to hear what worked and what didn't work for your family as you transitioned from work to retirement.

Excellent.  It was hard to tell from your previous posts where you were in terms of planning.

As far as what worked and didn't work for us, our situations are quite a bit different so I doubt that what we did would be of much help to you.  A few of the large differences include:

1.  DH is receiving a non-COLAed pension; there was no option to take a lump sum.

2.  DH's former employer subsidizes (not pays fully) our retiree medical premiums to the tune of $800/mo.  Whether we will have retiree medical in 2015, due to Obamacare, remains to be seen.

3.  Our deferred and taxable account balances are quite a bit different than yours, but we live in a VERY high COLA area.  We have a sizable, but cheap mortgage that we could pay off, but choose not to.   We see it as a hedge against future inflation.

4.  I think you did mention Roth IRA conversions.  We will be doing T-IRA to Roth IRA conversions over the next few years before we start taking SS (haven't decided when that will be yet) to reduce RMDs when we turn 70 1/2.

All I can say is, so far so good.  To date we have yet to withdraw money from any of the retirement accounts.   

[dancinmama]

Jan 6, 2014 14:57:06 GMT -5 bookkeeper said:

We have been told by the retirement professionals at DH's company that we can determine the amount we want to draw from the retirement accounts, not the government, because DH does meet the 55 years of age and 30 years of participating in the same retirement plan. We will revisit this in March when we have another sit down appointment with the retirement specialists.

DH is getting really burnt out at his job.  He has finally allowed himself to start looking forward to the end.  One end and one beginning.

I hear ya on that one!! 

[dancinmama]

Jan 6, 2014 14:57:06 GMT -5 bookkeeper said:

We have been told by the retirement professionals at DH's company that we can determine the amount we want to draw from the retirement accounts, not the government, because DH does meet the 55 years of age and 30 years of participating in the same retirement plan. We will revisit this in March when we have another sit down appointment with the retirement specialists.

DH is getting really burnt out at his job.  He has finally allowed himself to start looking forward to the end.  One end and one beginning.

That is true for the 401k for sure.  For lump sum distribution, it would depend on what type of account it was put in upon retirement and I thought you posted that it was going to be rolled into an IRA.  Once the money is rolled into the IRA, you are restricted by the rules for withdrawals on IRAs regardless age/years of participating in the same retirement plan.  

Example:  Even though DH participated in his 401k plan for over 32 years nd retired at age 56, IF he rolls that money into an IRA (which he can do at any time), the money then falls under withdrawal rules for IRAs.  To avoid paying the 10% early withdrawal penalty, he would either have to wait to withdraw anything until age 59 1/2 or as you mentioned earlier, take withdrawals under the 72T provision (which spreads payments over your expected life span dictated by tables used by the government to determine how much you can or have to withdraw and pay taxes on).  

Clarification in March is a good idea.  Perhaps there are other provisions for lump sum distributions deposited into IRAs that I am not aware of.   Like I said, I'm not a tax expert so that's entirely possible. 

[bookkeeper]

Here is an update for our situation.

We met with the retirement specialist again in March. The 1.5 mil lump sum defined benefit will roll over into the 401k. I had that part wrong. I believe I was incorrectly informed. Anyway it will roll into the 401k.

We met with the CPA today. He advised us to draw the deferred income money first, followed by the 401k money, and the Roth accounts last. He could see no benefit to moving anything to an IRA.

I have been reading and working to educate myself so there are no surprises either with the withdrawals or the tax liability. 

The last piece of the puzzle seems to be how we want to structure residency and our withdrawals.

I need to sit DH down and figure out a budget/withdrawal schedule that everyone can live with.  As far as the income tax, the CPA feels, as I do, that income taxes will only go up.  Pay the tax on your withdrawals as you go and get it over with.  We will have the income tax withheld from the payment as we receive the money rather than deal with quarterly payments.

Thank you all for your insights.  As I re-read this post today, I can see that I had more to learn (probably still do). 

[TheOtherMe]

Will a penalty apply for withdrawing the 401K money before age 59 1/2?

[tallguy]

The 1.5 mil lump sum defined benefit will roll over into the 401k.

Will a penalty apply for withdrawing the 401K money before age 59 1/2?

There should not be a penalty if they follow a 72T distribution schedule for five years.  My question would be if the lump-sum has to be rolled into the existing 401k with the $500,000 balance?  If it does, the required distribution may be larger than they would prefer.  If only some of that money is needed, it would be better to have the $1.5M rolled into a segregated account and then decide from which account to do the 72T distribution schedule.   Easier that way to control how much you have to withdraw, isn't it?  

[bookkeeper]

DH is 55 years old and retiring from a qualified retirement plan, therefore we have been "told" recently by the retirement specialist that we will not need a 72T as long as we keep the money in the 401k.  We should not have a penalty either because he has met the age of 55 and has separated from service (retired).

If he was not yet age 55 the rules would be different and we would need the 72T.  Right now we do not anticipate needing to use the 72T provision.

[tallguy]

Apr 23, 2014 7:14:53 GMT -5 bookkeeper said:

DH is 55 years old and retiring from a qualified retirement plan, therefore we have been "told" recently by the retirement specialist that we will not need a 72T as long as we keep the money in the 401k.  We should not have a penalty either because he has met the age of 55 and has separated from service (retired).

If he was not yet age 55 the rules would be different and we would need the 72T.  Right now we do not anticipate needing to use the 72T provision.

True, you do not need to withdraw it just because he is leaving employment.  The 72T is only if you withdraw the money for use instead of either leaving it in the plan or rolling it over.  Correct?

 

[bookkeeper]

We plan to draw from the 401k in about 16 months.  We are going to need to access that money to pay our living expenses.  There is no need to set up a 72T withdrawal because he can access the 401k without any penalty at age 55 with a separation of service as per the plan requirements.

I believe the 72T comes into play if you are not yet 55 years of age.  My neighbor retired at 53.  He was not able to access his 401k because he quit his job before the age requirement.  He rolled his lump sum defined benefit into an IRA where it must sit until he is 59 1/2.  He is considering setting up a 72T to access some of his money. In this example, he would have had full access to his money if he had worked two more years.

Another co-worker of DH wanted to buy a new house.  He decided the money to purchase the house was in his 401k. He was over age 55 and had to quit his job to access the money. The 401k plan did not allow a raiding of the account without a separation of service. Apparently the 401k loan option that was available to him did not appeal to him. This was a poor move that undoubtedly caused a large tax bill.

These examples are why I am striving to do this in the correct fashion. One or two wrong moves can force you into a place you do not want to be.