Immediate distribution is a financial term that usually refers to the choice of receiving the benefit of a 401(k) plan or pension as a lump sum payment for the entire balance. Instead of taking payments over the course of retirement, you can withdraw the entire policy in one payment.
Definition and Examples of Immediate Distribution
Immediate distribution means withdrawing the full balance of your retirement account in one lump sum instead of taking smaller distributions over time. While immediate distribution is often taken as a single payment, multiple payments that comprise the full balance of the plan can be considered an immediate distribution if made within the same tax year.
An immediate distribution can also occur in the following cases:
- Upon the death of the plan participant
- Once the participant reaches age 59 and a half
- Due to the participant leaving the employer sponsoring the retirement plan
- After the account holder becomes permanently and totally disabled
Note: The plan referred to may also be a profit-sharing plan or a stock bonus plan.
Choosing an immediate distribution is typically one of a few options you will have. You can also roll over the account balance to another retirement plan, take a partial distribution, or keep the benefit in the current account as long as the plan or account custodian allows it.
Immediate distributions are often not the best option for an individual, as they can have serious tax consequences. For example, suppose your 401(k) account balance is $100,000, and you have 100% vested ownership of your benefit. If you decide to “cash it out” and take a check payable to you, the amount you will receive will be significantly less than $100,000 after taxes, but in some cases, this may be the best option.
How Does Immediate Distribution Work?
You usually keep most of the money in your retirement account to continue earning interest. Then, once you stop working, you take periodic distributions as part of your retirement income.
In some cases, you may not be able to leave the funds in your retirement account. For example, if you leave the employer that funds your 401(k) plan, you may not be allowed to keep your money in the company plan indefinitely.
If you decide to withdraw everything as an immediate distribution, there may be significant tax consequences. Your options in this case are to take it either as cash (a check payable to you) or as a transfer (a check written to your trust account or another account on your behalf).
Avoid Receiving a Check Payable to You
If you can avoid it, you do not want to receive your distribution as a direct payment to you. When you do, the distribution becomes taxable.
This new tax situation comes into play because your contributions to your 401(k) plan, in most cases, were deducted from your pay on a pre-tax basis. This means they were not taxed.
In most cases, 20% will be withheld from the cash distribution for federal taxes. From a $100,000 distribution, this rate will leave you with a check for $80,000. Additionally, you may face a 10% tax penalty if you withdraw the funds before reaching age 59 and a half. This rate will leave you with a check for $70,000.
You are required to withhold 20% of tax when you receive a cash distribution directly, even if you intend to roll it over to another retirement plan within 60 days. If you complete the rollover in time, you can use the outside funds to recover the withheld amount and defer paying the tax.
Note:
If you are unable to complete the rollover process within 60 days, you may be able to claim that you meet the conditions for an exemption from this requirement.
Money Transfer
The best thing you can do with your 401(k) plan is to choose the IRA rollover option. This rollover may still be considered an immediate distribution, but instead of receiving a check made out to you, you will receive a check made out to your IRA custodian, or your custodian will receive the check directly.
For example, let’s say you opened an IRA with Vanguard. When you stop working for your employer and receive your 401(k) distribution options, you will choose the option that says something like “rollover to IRA.” The check will be made payable to Vanguard (not to you personally). If done correctly, the check will also say “FBO [your name],” which means “for the benefit of [your name].”
When the check is made out to Vanguard instead of you, you do not pay taxes or penalties on the distribution. This is because you never actually received the money at any point.
Note: If you were born before January 2, 1936, you have additional options for how to treat the immediate distribution. You may be able to report part of it as capital (for the money you paid in before 1974), and you can spread the tax on the total amount over 10 years.
How to Invest the Immediate Distribution
Once your IRA custodian receives the check for the rollover, you will have cash in your IRA that needs to be invested. You have two basic options: invest it all at once, or invest it in installments over time.
If you wish to invest it all at once, you should be careful to diversify the risks (spreading the risks across several different types of investments). You can do this through a portfolio of mutual funds.
If you want to mitigate market risk, you can use the dollar-cost averaging (DCA) technique to invest a set amount of money monthly in the mutual funds you have chosen over a specified period, such as a year. This way, if the market fluctuates significantly, you will buy some shares at higher prices and some shares at lower prices. This process will average your costs and use your money more effectively. Most investors will find that DCA is more effective than trying to time the market.
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Sources:
Internal Revenue Service. “Topic No. 412 Lump-Sum Distributions.”
Internal Revenue Service. “Topic No. 413 Rollovers From Retirement Plans.”
Source: https://www.thebalancemoney.com/lump-sum-distribution-definition-2466686
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