Lump-sum payouts bring risks Workers need to study options to avoid losing long-term gain.

October 23, 1991|By Georgia C. Marudas | Georgia C. Marudas,Evening Sun Staff

It's a nightmare come true. You've been laid off.

You have so much to think about -- how to best stretch your severance pay, how to pick up your health insurance, how to start looking for another job.

With those pressing worries, there's a chance that you might overlook one issue that could affect you and your family years later: What do you do about your retirement funds?

With the recession taking its toll on corporate payrolls, more and more people under retirement age are finding themselves eligible for a lump-sum payout from their retirement plans.

The Investment Company Institute, a mutual fund trade group, estimates that in a given year 7.1 million people who undergo an unplanned job change are eligible for nearly $7 billion in lump-sum distributions averaging $9,500 each.

This could be a distribution from a defined contribution plan -- one in which a specified amount of money is put regularly into a retirement account for the employee -- such as a 401(k), profit-sharing or employee stock ownership plan.

Or, if your employer's plan allows it, it could be from a defined benefits plan, which promises to pay a specified monthly benefit retirement; a payout from a defined benefit plan would mean you would not get regular pension payments in retirement.

Laid-off government employees also can be entitled to distributions from some retirement plans. State employees who participate in one of the several defined contribution supplementalretirement plans can take their money out if they are terminated.

If you receive a lump-sum payout, you have several options: Roll the money over into another qualified retirement plan within 60 days -- the Internal Revenue Service deadline -- to preserve its tax-deferred status; take the money and pay the tax and probably a penalty, or leave the money in the company plan if it's allowed.

What you do with that distribution can have a major impact on your future financial resources. For most workers under retirement age, the advantages of reinvesting that money -- or rolling it over -- in another qualified retirement plan are numerous:

* You preserve its tax-deferred status; taxes aren't paid until you withdraw funds, presumably after retirement when your tax rate probably is lower.

* You don't pay an early withdrawal penalty.

* Your money continues to compound on a tax-deferred basis.

* You continue to build assets for retirement income.

Alarmingly, most people under retirement age who receive payouts are spending the money instead of rolling it over. A survey by the Employee Benefit Research Institute, for instance, found that only 13 percent of the workers who ever had received a lump-sum payout put all or part of it back into another tax-deferred qualified retirement plan. Some put the money into savings accounts, some paid off debt, and some just spent it.

"If you look at the people who actually took the cash-out, most spent the money," says EBRI researcher Joseph S. Piacentini.

Your age and financial situation are key factors in making the decision, experts say. You need to fully understand just how much it will cost you in taxes if you don't roll a distribution over; you should understand the effects on your retirement income; and, assuming you roll your money over, you have to make a decision on how to invest it.

The tax consequences of not rolling a lump sum over can be dramatic. First, the money becomes taxable as current income. Second, if you are under 55 -- and in some cases between 55 and 59 1/2 -- you also will pay a 10 percent early withdrawal penalty.

"You'd be amazed at how many people take the money and pay that tax and penalty," says Andrew Tignanelli, a certified public accountant and financial planner who heads Coordinated Assets Columbia.

"A lot of people when they're laid off panic -- they're afraid -- and they take any cash they can get and they're willing to pay the penalty," he says. "Many are dazzled by the lump-sum amount. They've never seen that much money at once."

But the decision to use the money can be costly.

As an example, Tignanelli cites a worker under 55 in the 28 percent federal tax bracket who gets a $10,000 lump-sum distribution.

"He pays the 10 percent penalty -- $1,000 -- and $2,800 to the IRS. You have to understand you pay income tax on the whole amount, not the $9,000 left after the penalty. And 7 1/2 percent -- $750 -- to the state of Maryland. Right away you're at 45 1/2 percent [$4,550] that you're going to pay," he says.

Workers also can choose whether to have tax withheld from a lump-sum distribution, and "99.9 percent check no," Tignanelli says. Then, often, he says, they don't realize how much tax they owe until April 15 rolls around, and by the time it does, the money has been spent.

Baltimore Sun Articles
Please note the green-lined linked article text has been applied commercially without any involvement from our newsroom editors, reporters or any other editorial staff.