What Is a Lump-Sum Distribution?
A lump-sum distribution is a one-time lump-sum payment from an amount of money owed to some party, rather than via payments brokeninto smaller installments. In certain cases, lump-sum distributions may receive special tax treatment. Lump-sum distributions are commonly associated with choosing how to receive windfall earnings, such as from winning the lottery, or from a retirement or pension plan. Lump-sum distributions can be contrasted with annuitized distributions.
Key Takeaways
- A lump-sum distribution is an amount of money due that is paid all at once, as opposed to being paid in regular installments.
- Lump-sum distributions may be made from retirement plans, commissions earned, windfall earnings, or certain fixed-income investments.
- A lump-sum will typically be discounted to its net present value (NPV).
- A lump-sum distribution is not always the best choice for every beneficiary; for some, it may make more sense for the funds to be annuitized as periodic payments.
How a Lump-Sum Distribution Works
It is not always best to take the lump-sum payment in lieu of periodic annual payments; if offered the choice, consider taxes, investments, and thenet present value (NPV), which accounts for the time value of money.
Two common examples of lump-sum distributions are a commission check and a pension plan distribution, following a pensioner’s death.
In general, distributions from qualified plans are treated as lump sumsif the total plan balance is distributed over the same tax year,and if the distribution is made as a result of the employee:
- Attaining age 59½
- Being deceased (applicable to beneficiaries)
- Separating from service (not applicable to self-employed individuals but applies to their common-law employees)
- Being disabled (applicable only to self-employed individuals)
Pension plans don't allow participants to take early withdrawals or loans from the funds.
Lump-Sum Distribution and Qualified Retirement Plans
If a pension plan owner passes away, a lump-sum distribution will often transfer to a beneficiary or beneficiaries. These can be relatives, close acquaintances, or even institutions such as charities. Beneficiaries can be revocable or irrevocable, have discretionary powers (or not).
Qualified plans generally fall into two categories: defined benefit and defined contribution. Defined benefit plans give employees a guaranteed payout; this places the risk on the employer to save and invest properly to meet plan liabilities. For employees in a defined contribution plan, the amount they receive in retirement depends on how well they save and invest on their own behalf during their working years. A 401(k) is the most popular example of a defined contribution plan.
Other examples of qualified plans that may grant lump-sum distributions include:
- Profit-sharing plans
- 403(b) plans
- 457 plans
- Money purchase plans
- Target benefit plans
- Employee stock ownership (ESOP) plans
- Keogh (HR-10)
- Simplified Employee Pension (SEP)
- Savings Incentive Match Plan for Employees (SIMPLE)
The Internal Revenue Service (IRS) provides a comprehensive guide to common qualified plan requirements. This guide breaks down each plan and who theybest suit, draws comparisons among them, and notes risks or concerns for potential or current investors.
Commission Check and Qualified Retirement Plans
Commission checks are another example that can be paid out as lump-sum payments. Commission checks apply to roles mainly in sales and marketing either as sole earnings or in addition to a base salary. Employers often use sales commissions to incentivize workers to produce more value. Several major types of commission checksinclude a base salary and commission,straight commission, draw against commission,and residual commission.
Lump-Sums Versus Annuity Payments
To illustrate how lump-sum and annuity payments work, imagine you won $10 million in the lottery. If you took the entire winnings as a lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket.
However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million of income in one year, your annuity payment might be $300,000 a year. Although the $300,000 would be subject to income tax, it would likely keep you out of the highest state tax brackets. You would also avoid the highest federal income tax bracket of 37% (as of 2020) for single people with incomes greater than $518,400 or $622,050 for married couples filing jointly.
In 2021, those figures go up. Single people with incomes greater than $523,600 and married couples filing jointly with incomes up to $628,300 are in the 37% tax bracket. Such tax questions depend on the size of the lottery win, current income tax rates, projectedincome tax rates, your state of residency when you win, in which state you will live after the win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump sum option usually makes more sense with a 30-year annuity.
Another big advantage of taking the money over time is that it provides winners with a "do-over" card. By receiving a check every year, winners have a better chance of managing their money properly, even if things go badly the first year.
FAQs
What's a lump-sum distribution? A lump-sum distribution is the distribution or payment within a single tax year of a plan participant's entire balance from all of the employer's qualified plans of one kind (for example, pension, profit-sharing, or stock bonus plans).
How does a lump sum payment work? ›
A lump-sum distribution is an amount of money due that is paid all at once, as opposed to being paid in regular installments. Lump-sum distributions may be made from retirement plans, commissions earned, windfall earnings, or certain fixed-income investments.
What is the lump sum payment structure? ›
Two parties enter an agreement with a set fee. The owner of the contract agrees to pay the contractor the agreed-upon price. The 'lump sum' refers to this total price, not the payment schedule – owners will usually pay in regular installments.
How do you explain lump sum? ›
A lump sum is a single payment of money, as opposed to a series of payments made over time (such as an annuity).
What are the disadvantages of taking lump sum pension? ›
What Are the Disadvantages of Taking a Lump Sum on Your Pension? Perhaps the greatest risk of cashing out a pension early is the prospect of running out of money. With life expectancies rising, many retirees face the increasing likelihood that they may outlive their savings, especially if they spend it.
What is an example of lump sum payments? ›
An example of a lump sum payment would be if someone won the lottery and received their winnings all at once in one large payment. Another example might be if someone sold their house and received the entire sale price in one lump sum.
What is lump sum cash payout? ›
Lump sum payment is a single payment of money i.e., one-time payment, as opposed to installations or series of payments. It is most commonly used in the context of pensions, when one has the option of receiving a lump-sum pay-out from your pension provider or smaller payments over time, or a combination of both.
Is it better to pay lump sum or monthly? ›
Bottom Line. Deciding between taking a lump sum or regular monthly payments requires evaluating your expected life span as well as how soon you can receive the lump sum. A longer life expectancy tends to favor monthly payments, while the sooner you can get the lump sum, the better that option looks.
Why are lump sum payments good? ›
Much like extra repayments, a lump sum payment can have a significant impact on the life of your home loan and the amount of money you can save. Making a lump sum payment, particularly in the early years of your loan, can have a big effect on the total interest paid on the loan.
What is a lump sum payment at the end of maturity? ›
A bullet repayment is a lump sum payment made for the entirety of an outstanding loan amount, usually at maturity. It can also be a single payment of principal on a bond. In terms of banking and real estate, loans with bullet repayments are also referred to as balloon loans.
The future value of your lumpsum investment in mutual funds is calculated using the formula A = P*(1 + r) ^ t, where A represents the future value, P denotes the principal investment amount, r signifies the expected rate of return, and t indicates the duration of the investment.
Is a lump sum income? ›
Lump sum income is irregularly or infrequently received income. It can be earned or unearned income. Whether lump sum income is counted when determining income eligibility depends on what is received, how often it is received, and the health care program for which the person is eligible.
Will my monthly payments go down if I pay a lump sum? ›
When you make a lump-sum payment on your mortgage, your lender usually applies it to your principal. In other words, your mortgage balance will go down, but your payment amount and due dates won't change.
How do they calculate pension lump sum payout? ›
The amount of the lump sum is based on a formula that your pension provider determines using factors including IRS-mandated interest rates, your age, and mortality tables. 2 The lump-sum offer is supposed to equate to taking your monthly pension payments as one large sum.
Does a lump sum pension get taxed? ›
All money received from a pension is taxed as ordinary income, regardless if you receive monthly payments or take it as a lump sum.
What is the 6% rule for lump sum pension? ›
If the number is below 6 percent, then you could do as well (or better) by taking the lump sum and investing it, and then paying yourself each year (like a personal pension that you control). Here's how the math works: Take your monthly pension offer and multiply it by 12, then divide that number by the lump-sum offer.
Do lump sum payments get taxed? ›
Mandatory income tax withholding of 20% applies to most taxable distributions paid directly to you in a lump sum from employer retirement plans even if you plan to roll over the taxable amount within 60 days.
Is it better to take a lump sum or monthly payment? ›
If you expect to have an above-average life span, you may want the predictability of regular payments. Having a payment stream that will last throughout your lifetime can be comforting. However, if you expect to have a shorter-than-average life span because of personal reasons, the lump sum could be more beneficial.
How to avoid taxes on lump sum payout? ›
Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts.
