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Lump Sum Distribution

This Life Advice® pamphlet about Lump Sum Distribution was produced by the MetLife Consumer Education Center and reviewed by the International Association for Financial Planning and the Internal Revenue Service (IRS).

What Is a Lump Sum Distribution?
What Are Your Options?
What Is a Traditional IRA?
More Tax Tips
Asset Allocation Questionnaire
Allocating Your Lump Sum Assets
Some Words to the Wise
For More Information

You've worked hard and saved for the future. Now perhaps you're retiring, or you may be changing jobs. Either way, you're ready to take the money from your pension, 401(k) or similar retirement plan and make it work for you. You've got a number of decisions to make as you figure out how to manage your nest egg, and this pamphlet will provide you with some questions and answers to help you achieve the results you want. You may wish to consult a financial planner or tax advisor for additional advice on handling your lump sum distribution, in particular since lump sum averaging generally will be unavailable beginning January 1, 2000.

What Is a Lump Sum Distribution?

A large sum of money is about to come your way, courtesy of your retirement fund. A lump sum distribution may come to you whenever you're separated from your employer, whether due to retirement, a job change or layoff. Depending on how long you've been with your employer, you may have to manage a lump sum distribution of $20,000, $200,000 or more.

To be considered a lump sum distribution for tax purposes, the following must apply:

• The money must come from an IRS-qualified plan, such as a 401(k), profit-sharing or other approved pension plan.
• It must be payable due to separation from service (but not if you are self-employed), death, disability (only if you are self-employed) or after you have reached age 59½.
• You must receive the entire amount in your account within one tax year.

What Are Your Options?

There are a number of ways to handle a lump sum distribution, each with its own tax ramifications. Here's an overview of four alternatives:

1. Take your money and pay the taxes. This may be an option to consider if the lump sum is small or if you have a pressing need for the money to pay bills, tuition or a mortgage. The primary drawback is that you will lose a large chunk of money immediately to taxes. What's more, you lose the benefit of tax deferral unless you reinvest the money in a tax-favored investment such as a tax-exempt mutual fund or a tax-deferred annuity, which means any future earnings on the remaining balance, if invested, will be taxed as they are earned.
   
   The following example demonstrates what would happen if you received a taxable distribution of $100,000 and took the money as current income:
   
   

   Original lump sum	$100,000
   Less mandatory 20% withholding	$ 20,000
   Received at payout:	$ 80,000
   Less additional ordinary income tax (remainder due on original amount after 20% withholding, assuming a 28% bracket)	$ 8,000
   Amount remaining after taxes	$ 72,000

   
   
2. Take the lump sum and use tax averaging. Ten year averaging is available for an individual. Averaging allows you to figure your tax as if you had received your lump sum over a 10-year period. Although you still must pay the total tax liability in the first year, your tax savings could be substantial. Generally, the larger your lump sum distribution, the less you save in taxes. To be eligible, you must have been born before January 1, 1936 and you must have participated in the plan for a minimum of five years before the year of distribution and reached age 59½. Averaging is not available to you if you own 5% or more of the company but only to the extent of amounts determined to exceed benefits provided under the plan formula. You must apply tax averaging to your entire distribution and to other lump sum distributions received in the same tax year. You must not have used averaging before (unless it was prior to 1986); this is a one-time-only election. Additionally, if you participated in the plan before 1974, some portion of your distribution may qualify for a flat 20% capital gains rate. There are many rules and restrictions on tax averaging. If you think you qualify for 10-year averaging, you may want to consult with your tax advisor to see which tax option would be most advantageous to you.
   
   As is the case with taking the money outright, you not only have to pay taxes immediately but you lose the advantages of tax-deferred earnings with this option unless you deposit the money into another tax-deferred vehicle.
3. Deposit the money into a traditional IRA, other qualified retirement plan or a new employer's plan. The advantage of moving your money to another qualified plan is that it may continue to grow tax-deferred until you begin withdrawing it, when it will be taxed as ordinary income. There are several ways to deposit the lump sum in a traditional IRA or other qualified plan.
   
   •  Arrange a direct rollover. Your current employer deposits your funds directly into a traditional IRA or other retirement plan. You never personally take receipt of the money. This eliminates the IRS requirement that the employer withhold 20% of the distribution. Experts strongly recommend this method.
   •  Convert your traditional IRA to a Roth IRA. After your employer deposits your funds directly into a traditional IRA, you have the option to convert it to a Roth IRA. The Roth IRA allows withdrawals of earnings federal tax free, provided certain requirements are met. However, the conversion of the traditional IRA to a Roth IRA would cause your entire traditional IRA balance, excluding non-deductible contributions, to be subject to current income taxation. It also allows contributions up to your annual earned income or the amount shown in the chart below per year whichever is less.
   
   

   Year	Contribution Amount
   2002	$3000
   2003	$3000
   2004	$3000
   2005	$4000
   2006	$4000
   2007	$4000
   2008	$5000

   
   Roth IRA contributions up to the annual contribution limit may be made by taxpayers with Modified Adjusted Gross Incomes (MAGIs) at or below $150,000 for joint filers or $95,000 for single filers. For incomes above these limits, the allowable contribution phases out gradually. However traditional IRA owners can convert part or all of their traditional IRA to a Roth IRA provided the taxpayer’s MAGI is not above $100,000, excluding the amount of the conversion. (Note: Married taxpayers who file separately are not eligible for this conversion.) The decision to convert or retain an existing IRA will probably involve some tradeoffs, so you should weigh your options carefully. Consult your financial professional or tax advisor to help you choose the best IRA option for you.
   •  Take receipt of the lump sum and then deposit it within 60 days to a traditional IRA or a new retirement plan. There are two very big drawbacks to this option. If you miss that 60-day deadline, even by a day, you will owe tax on the entire sum. Also, if you take receipt of the money yourself, even for a short time, your employer must deduct 20% withholding tax from the total. You will receive only 80% of your money. If you decide within 60 days to make up the 20% with your own money and roll over the full amount, you will eventually receive a refund of the 20% withholding tax, but in the meantime you will have to come up with it out of your own pocket for purposes of the rollover. If you can’t make up the missing 20%, it will be taxed as income. If you roll the money over into a traditional IRA, be sure to establish a special "conduit IRA."
   
   If you do not commingle the funds from your lump sum distribution with any other funds, you may have the option of one day transferring those funds to another employer's plan.
   
   What Is a Traditional IRA?
   
   A traditional Individual Retirement Account (IRA) is a tax-deferred retirement savings vehicle controlled by you. You decide how the money is invested and when to withdraw it. Withdrawing only what you need allows you to control how much you live on and when you pay income taxes. You may be required by law to take certain minimum distributions after reaching the age of 70½. If you make withdrawals from your IRA before age 59½, you generally will be subject to a 10% tax penalty on the taxable portion of the withdrawal.
4. Leave the money in your current employer's plan. This may make sense if your employer’s plan offers better interest rates or investment options than other savings or investment plans. Leaving your money with your former employer has no immediate tax consequences, and you can always roll the money into an IRA at a later date. The professional management of the fund is another plus, especially if you are uncomfortable making investment decisions. Disadvantages may include a limited number of transactions and restricted investment choices. Also, if your vested account balance does not exceed $5,000 this option may not be available.
   
   If you die, your beneficiary may also be able to leave the account with your employer for a certain period of time. This differs by plan, so check with your employer for guidelines.

More Tax Tips

You'll probably want to ask your accountant or financial advisor for help in comparing the amount of taxes you would pay under the options outlined above. But there are a few other tax considerations to keep in mind as you make your decisions:

• Don't forget that 10% early withdrawal tax penalty. It generally applies when you receive a lump sum distribution prior to age 591Ú2 and do not transfer it directly to an IRA or other qualified plan. Specific exemptions may be made for withdrawals due to death, disability and certain medical expenses or if you separate from service from your employer at age 55 or older.
• Money contributed to your retirement plan on an after-tax basis will come to you tax-free. All earnings on this money, however, are subject to tax. When you leave a company or retire, you should be provided with a statement of your account outlining pre- and post-tax contributions.
• Tax laws are subject to change. Always consult with a tax professional on the latest rules.
• Consider state and local taxes. Some states exempt pension income; other states may tax it. Consult a tax professional for the laws in your area.

Asset Allocation Questionnaire

Ibbotson Associates created this questionnaire specifically for MetLife. Ibbotson Associates is a financial services consulting firm widely recognized and respected by the financial services industry for its research and educational services. The following questions will enable you to determine your time horizon and risk tolerance levels so that you can select an appropriate asset allocation portfolio model. Please answer all of the questions and then calculate your score as indicated and select the suggested asset allocation portfolio on the provided table. Please remember these are only suggested allocations; the final decision is up to you.

1A. When do you expect to begin using this money?

a. 0-2 years
b. 3-5 years
e. 6-10 years
d. 11 years or more
e. I plan to leave this money to my heirs. (If this answer is selected, proceed to question 3.)

1B. Once you begin using this money, how long do you need it to last?

a. 0-11 months
b. 1-5 years
c. 6-10 years
d. 11 years or more

2. As the cost of living goes up, your money will buy less and less over time. This is called inflation. Which statement best describes how concerned you are about inflation?

a. I am willing to take a lot of risk to have my investment portfolio grow much faster than inflation.
b. I am willing to take moderate risk to have my investment portfolio grow faster than inflation.
c. I am willing to take a small amount of risk to have my investment portfolio grow slightly faster than inflation.
d. I am satisfied with having my investment portfolio keep pace with inflation, as long as I take very little risk.

3. Choose the answer that best describes your response to the following statement: I am comfortable with investments that will periodically decline in value if there is a potential for high returns.

a. Strongly disagree
b. Disagree
c. Somewhat agree
d. Agree
e. Strongly agree

4. The graph shows the probable range of returns and losses of five hypothetical portfolios over a one-year-period. Notice that portfolios with high returns also have the probability of experiencing large losses. In which of these portfolios would you prefer to invest?

a. Portfolio A
b. Portfolio B
c. Portfolio C
d. Portfolio D
e. Portfolio E

5. The charts below show the average annual returns for three hypothetical investments over a 20-year period. Given the volatility of the returns for these three investments, which would you choose?

a. Portfolio A

b. Portfolio B

c. Portfolio C

The illustration above is for illustrative purposes only. Source: Ibbotson Associates: 2001.

6. For many investors, the possibility of losing money is a primary concern. Which statement best describes your attitude toward investment losses?

a. I check the values of my investments quite often, so I can sell quickly if they begin to lose money.
b. Daily losses in the values of investments make me uncomfortable but do not cause me to immediately sell. However, if my investments suffer a substantial loss over a period of time, I would probably sell.
c. I realize that there may be large day-to-day changes in the value of my investments. However, I usually wait an entire year before making any changes.
d. Even if the value of my investments suffer large losses over a given year, I would continue to follow a consistent long-term investment plan and stick with my portfolio.

7. You have $10,000 to invest for one year and must choose one of the portfoliois below. The portfolios that offer greater ending values also have a greater chance of loss. Which hypothetical portfolio would you choose?

a. Portfolio A
b. Portfolio B
c. Portfolio C

What can happen to a $10,000 portfolio in 1 year

Calculate Your Scores
The first step in determining an asset allocation portfolio that is right for you is to calculate your time horizon and risk tolerance scores. Select the numerical score that corresponds to the answer you selected for each of the questions on the questionnaire and write it in the indicated box for each question. Add up your score as indicated to arrive at your time horizon and risk aversion scores.

LOOK UP YOUR SUGGESTED PORTFOLIO

To pick the portfolio that reflects your time horizon and risk tolerance, look in the adjacent table and find your Risk Score (down the left side) and Time Horizon Score (across the top). The portfolio number in the intersecting grid position is the recommended asset allocation portfolio for you.

Asset Allocation Models

Allocating Your Lump Sum Assets

Whether you have taken receipt of a lump sum or rolled it over into an IRA, you need to make decisions about how to invest your money so it continues to grow. Your first step is deciding how you feel about risk. This will allow you to allocate your investments in a way best suited for your needs. To help you determine your risk tolerance level, complete the Asset Allocation questionnaire above.

No matter what type of investor you are, it is important to diversify. That means allocating your money across different types of investments with different levels of risk so that you’re not putting all your eggs in one basket. You may place some of your funds in conservative financial vehicles with a guaranteed rate of return, while putting additional money in aggressive investments that carry more risk but have a possibility of greater returns.

You’ve got plenty of choices in deciding how to invest your IRA or lump sum. Just remember never to invest in a product you don’t fully understand. Here’s an overview of some of the most common opportunities:

Savings Accounts. A savings account, generally offered by a bank, is a good place to store emergency funds and money for short-term use. Your money is generally insured by the FDIC up to $100,000, and you have ready access to your money. The main drawback is low return. The interest rate paid on a savings account is often less than the rate of inflation, so your buying power may be eroded. That may make savings accounts unsuitable for long-term goals.

Money Market Accounts. These accounts, generally available through banks and brokerages, usually earn slightly higher interest than a savings account but still allow easy access to your money. Some banks and financial institutions require an initial deposit of $1,000 or more and limit the number of withdrawals or transfers you can make during a given period of time. Bank money market accounts also are generally FDIC insured. Brokerage houses and other financial institutions are generally not FDIC insured.

Certificates of Deposit (CDs). CDs generally earn more interest than savings accounts with equally little risk, but with less liquidity. Like savings accounts, they are offered by banks and are generally insured up to $100,000 by the FDIC. You agree to keep your money in the CD for a fixed period of time, usually three months to five years. Generally, the longer the term of the CD, the higher the interest rate. If you need to withdraw money before the end of the time period, you’ll pay a penalty.

Fixed Interest Annuities. These contracts, issued by an insurance company, guarantee a rate of interest for a set period of time. Fixed interest annuities, like CDs, are generally considered low risk and have limited liquidity. Generally, interest under an annuity is not taxed until withdrawn. As with CDs, early withdrawal charges may apply. Also a 10% tax penalty generally applies to the taxable portion of a withdrawal taken prior to age 59½. They also provide an option to receive a guaranteed income for as long as you live. Since fixed interest annuities are not federally insured by the FDIC, you should check the financial health of the company issuing the annuity. Financial ratings of insurance companies are issued by rating companies such as Moody’s, A.M. Best or Standard & Poor’s. Their publications are usually available at your local library.

Bonds. Bonds represent loans made by you to federal or local governments or to a corporation with a promise that they repay you with a set interest rate in a predetermined period of time. Bonds are generally considered a less risky investment than stocks, although, if you sell before the bonds mature, their values are affected by interest rate fluctuations and they may be outpaced by inflation. However, if a bond is held to maturity you get the face value of the bond returned to you. Independent agencies such as Standard & Poor’s and Moody’s rate bonds in the marketplace according to default risk.

Stocks. When you buy a stock, you become a part owner of a company. In choosing stocks, you look for companies that you believe will do well over time. Be sure to thoroughly research companies you’re interested in, and make sure you understand the potential for profit or loss before you invest. If the company does well, you may receive dividends and/or be able to sell your stock at a profit. Conversely, if the company does poorly and its stock price falls, you may lose some or all of the money you invested. Stocks are generally considered higher risk, but the risk usually decreases with the more variety of stocks you own.

Mutual Funds. A mutual fund pools money from many investors and invests it in various securities such as stocks, bonds and money market instruments, allowing you to reduce (but not eliminate) risk. If you further diversify by purchasing shares in more than one type of mutual fund, your risk may be reduced even more. Mutual funds are generally considered a more liquid investment.

Variable Annuities. A variable annuity offers the same type of diversification as mutual funds, but with an option to offer guaranteed income for life. The variable annuity may offer a guaranteed fixed interest account, like that offered by a fixed interest annuity, along with an additional five or more investment accounts, each specializing in a different type of investment objective. You choose how much to put in each of the options.

Among the choices that may be available as individual mutual funds or as investment divisions within a variable annuity are:

• Money Market Funds. The assets in these funds typically consist of U.S. Treasury bills, Certificates of Deposit (CDs) and other commercial investments. You'll find them on the lowest rung of the risk ladder for mutual funds. On the other hand, they also offer the lowest potential for return.
• Bond Funds. Bond funds may specialize in federal, municipal or corporate bonds with short, medium or long terms. In general, high-grade bond funds are low- to moderate-risk investments, with a few lower grade bond funds categorized on the high-risk side.
• Balanced Funds. Blending both stocks and bonds, these funds allow diversification with potentially lower risk than pure stock funds, but also with a lower potential for return.
• Index Funds. These funds attempt to mirror the performance of designated market indexes, such as the S&P 500. These indexes are commonly used performance measures of the stock or bond market. Index funds invest in most of the same stocks or bonds found in the corresponding index and, accordingly, seek to match the performance of that index. Generally, they are adjusted to assume reinvestment of dividends. This middle-of-the-road approach generally puts index funds at the lower end of the risk spectrum for funds with similar objectives.
• Growth and Income Funds. Such funds invest in companies believed to have strong growth potential that also have a solid record of paying dividends. Growth and income funds fall in the middle of the risk spectrum.
• Growth Funds. These funds invest in relatively stable and established companies, which may or may not pay dividends. Growth funds are considered higher risk, so expect significant fluctuation in share price.
• Aggressive Growth Funds. These funds are generally comprised of stocks with greater-than-average potential for growth. Such stocks may include start-up companies, smaller companies or companies in high-risk industries. As a result, these funds have a high degree of risk as well as a high potential for return.
• International or Global Funds. International funds generally invest only in stocks from countries outside the U.S., while global funds invest in both foreign and U.S. companies. Investors in these funds take on a higher degree of additional risk, since international issues contain risks not present with domestic issues, such as currency exchange rate fluctuations and different economic conditions, governmental regulations and accounting standards. The potential risks and rewards are very high.

Some Words to the Wise

Keep in mind the following points when deciding how to handle any lump sum distribution you receive from a savings or retirement plan:

• Plan for a long life. Today people are living longer due to advances in medicine and better awareness of the need for good nutrition and exercise. Plan an investment strategy that will keep you financially secure.
• Plan on a number of sources to finance your retirement. For many retirees that will mean a three-legged stool of Social Security, a traditional pension and the income from your own savings or retirement plan. Your standard of living will likely depend on how well you manage the financial resources under your own control.
• Anticipate inflation. It's not how many dollars you have now that matters, but what those dollars will buy in the future. Inflation erodes a dollar's buying power over time. Factor in a steady rate of inflation when investing your lump sum. Aim for earnings that outpace the rate of inflation.
• Diversify your retirement investments. Don't put all your eggs in one basket. Diversifying means balancing your investments by placing some money in conservative investments with a guaranteed rate of return and some in more aggressive investments that carry more risk but have a potential for greater returns. The ideal mix depends on whether you are a conservative, moderate or aggressive investor and may change over time as your circumstances change.
• Get advice. Consult a qualified financial planner, accountant or tax advisor on how to handle your lump sum distribution in the most beneficial way.

Being on the receiving end of a large sum of money can be intimidating, but with careful planning you can make the most of your resources to look forward to a comfortable and secure retirement.

For More Information

PAMPHLETS FROM THE FEDERAL GOVERNMENT

The quarterly Consumer Information Catalog lists more than 200 helpful federal publications. For your free copy, write: Consumer Information Catalog, Pueblo, CO 81009, call 1-888-8-PUEBLO or find the catalog on the Net at www.pueblo.gsa.gov.

Internet Information

If you're on the Net, check us out. We're part of MetLife Online (www.lifeadvice.com).

January 2001
Revised: January 2006