Lump Sum Pension Tax Liability

[MxVRacer]

I have been offered a lump sum distribution of my earned pension from a previous employer.  What are the tax liabilities for taking this distribution in 2023?

[MayaD]

If you receive a  distribution  before you reach age 59½, in addition to the regular income tax, you may have to pay an early withdrawal penalty tax equal to 10% of any taxable portion of the distribution or withdrawal not rolled over

Lump-Sum Treatment Options

You can elect to treat the portion of a lump-sum distribution that's attributable to your active participation in the plan using one of five options:

1. Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and the taxable part of the distribution from participation after 1973 as ordinary income.
2. Report the taxable part of the distribution from participation before 1974 as a capital gain (if you qualify) and use the 10-year tax option to figure the tax on the part from participation after 1973 (if you qualify).
3. Use the 10-year tax option to figure the tax on the total taxable amount (if you qualify).
4. Roll over all or part of the distribution. No tax is currently due on the part rolled over. Report any part not rolled over as ordinary income.
5. Report the entire taxable part as ordinary income.

For more information please check irs.gov

[MxVRacer]

Thank you, Maya!  I am only 51, however, I became disabled after I was laid-off.  Does that change any of your suggestion(s)?

[MxVRacer]

Also, the amount is about $16,000 fully funded by my employer over my 6 years of employment.

[LindaS5247]

Pension and annuity distributions from qualified retirement plans are fully taxable.  Your pension distribution would be taxed as ordinary income.

Any taxable distribution paid to you is subject to mandatory withholding of 20%, even if you intend to roll the distribution over later.

Early distributions (i.e. prior to age 59 1/2) are subject to the 10% Early Withdrawal penalty.  

However, the IRS does make exception to the early withdrawal penalty if you are totally and permanently disabled.

You are considered disabled if you can furnish proof that you can't do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or be of a long, continued, or indefinite duration. You must have your physician complete a statement certifying that you had a permanent and total disability.

You would receive a Form 1099-R from your employer to report this on your 2023 tax return.  Box 7 should have a code 2 indicating this distribution is an exception to the early withdrawal penalty.  If it does not have a code 2, you would inform the IRS of your eligibility using Form 5329.  This form is available in Turbo Tax.  Follow the prompts when you enter your Form 1099-R.

Along with properly completing the form 5329, you should submit at least one signed letter from a licensed physician attesting to the severity of your disability. That will generally satisfy any questions IRS might otherwise have.  Your tax return would have to be mailed to the IRS.

Click here for additional information regarding Pension and Annuity Income and the disability exception for the early withdrawal penalty.

Click here for additional information on early withdrawals from your pension plan.

Click here for information on Form 5329.

[dmertz]

The employer is also required to offer the option of a direct rollover to another qualified retirement account like an IRA.  A direct rollover avoids the otherwise mandatory 20% tax withholding on the distribution and if rolled over to a traditional retirement account continues to defer taxes.  You also have the option to do a taxable direct rollover to a Roth IRA.

[MxVRacer]

I should be able to prove to the IRS the severity of my disability. I wouldn't be considering this option if I didn't need the money because of my disability for much needed home repairs.  Is there any chance that the 20% withholding could be partially refunded at the end of the year?

[dmertz]

With regard to MayaD's original suggestions 1 through 3, "if you qualify" means that you are required to have been born before January 2, 1936.  I suspect that you do not qualify for any of the special lump-sum tax treatments, otherwise you would also need to be asking about RMDs.

The amount by which your 2023 tax withholding (and any estimated tax payments for 2023) exceeds your 2023 tax liability becomes your 2023 tax refund that you would receive in 2024.

If your taxable income in 2023 will be around $16,000, it would probably make sense to avoid the mandatory 20% tax withholding on the pension buyout by doing a direct rollover of the distribution to a traditional IRA and then taking distributions from the traditional IRA as needed where you can decline tax withholding.  This will avoid having around $3,200 tied up until at least early 2024 when you could receive a refund.

The same penalty exception for disability applies to distributions from IRAs.  Having the money in an IRA also allows you the opportunity to spread the distributions over more than one year, potentially reducing the marginal tax rate on the distributions.