How to Avoid Taxes on a Lump Sum Pension Payout

When your pension matures, there are multiple distribution options that you can choose from. Unfortunately, many of these distribution methods result in a tax liability that reduces your payout. However, you can delay and even minimize taxes on a lump sum by rolling it over into an individual retirement account (IRA) or another eligible retirement plan. Here’s how to make it happen.

A financial advisor can help you explore ways to lower your taxes by optimizing your investments.

Pension Payout Distribution Options

Retirees have multiple distribution options when receiving a pension. These are four common choices that retirees make:

Single-life: Monthly payments are based on the life of the person receiving the payout.
Joint and survivor: Payments continue until both spouses pass away. The surviving spouse may receive the full distribution or a fraction of it, depending on the pension plan.
Life with period certain: The retiree receives lifetime income, but payments are also guaranteed for a minimum period of time in case the retiree dies quickly.
Lump sum payout: Instead of receiving a monthly income, the retiree receives a lump sum that he or she can invest in a separate account.

Tax Treatment of Pension Distributions

The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means they’re taxed at the highest income tax rates. The agency says that mandatory income tax withholding of 20% applies to the majority of lump sum distributions from employer retirement plans. However, this default rate may be too low depending on your tax situation.

As a retiree, when you get a lump sum pension payout, not only is this considered ordinary income, but the payout could also push your income into a higher tax bracket. And, depending on the size of the pension payout, it could trigger additional investment taxes on other sources of income. Furthermore, this could reduce your eligibility for other tax deductions and benefits. That’s why it’s important to consider your entire tax picture, not just the taxes on a pension lump sum, when deciding what works best for your situation.

Why Investors Choose a Lump Sum Pension Distribution

A couple taking their pension lump sum tax calculation into account.

While many investors prefer the regular payments that a pension provides, it isn’t always the best decision. Some investors choose to receive a lump sum distribution instead. Here are five common reasons why:

More control over their money: When you take a lump sum, you can make investment and distribution decisions that a pension does not offer.
Fear that pension will collapse: Many pensions collapse under financial obligations owed to retirees. When this happens, the government steps in to cover pensioners, but the payouts are often reduced.
Can shop annuity rates: When you receive a lump sum, you can still create monthly recurring income through an annuity. Instead of settling for the pension payout rates, you can shop your lump sum around to find the best rates and terms.
Roth conversion option: You can roll your lump sum payout directly into a Roth IRA. You will pay taxes on the amount converted, but future earnings and withdrawals can be tax-free if the account has been open for at least five years and you are at least age 59½.

How to Avoid Taxes on a Lump Sum Pension Payout

Investors can delay and minimize taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts. Here are two things you need to know:

20% withholding: Even if you plan on rolling over your pension payout, some companies withhold 20% for potential federal tax liabilities. This happens when the pension company issues you a check, so you only receive 80% of your lump-sum distribution. To roll over the full amount into your retirement account, you’ll need to replace the withheld 20% with other funds. If you don’t, the withheld amount will be treated as an early distribution and may be subject to taxes and penalties. For those who do replace it, the 20% withheld is returned when you file your taxes.
Direct rollover option: To avoid this, do not receive the payout directly. Instead, perform a direct rollover by requesting that the money be sent directly to your retirement account at the new investment company.

This process can be tricky for some investors, so the best approach can be to work with a financial advisor to complete the paperwork.

Frequently Asked Questions

1. Can I Avoid Paying Taxes on a Lump Sum Pension Payout?

You generally cannot avoid taxes entirely, but you can defer or reduce them. A lump sum pension payout is treated as ordinary income by the IRS. You can postpone paying taxes by transferring the lump sum straight into a traditional IRA or another eligible retirement plan. When done as a direct rollover, no taxes are withheld, and you postpone paying income tax until you withdraw the money in retirement.

2. What’s the Difference Between Direct vs. Indirect Rollovers?

A direct rollover transfers funds from your pension plan directly to an IRA or another qualified plan. No tax is withheld, and the transfer is tax-free. An indirect rollover means the plan cuts you a check. The payer must withhold 20% for federal taxes, and you have 60 days to deposit the full amount (including the withheld 20%) into a new account. If you don’t, the IRS treats the amount as taxable income and, if you’re under age 59 ½, it may trigger a 10% early withdrawal penalty.

3. What Is the 20% Federal Withholding Rule on Lump Sum Distributions?

When a lump sum distribution is paid directly to you, the plan administrator must withhold 20% for federal income taxes, even if you intend to roll it over later. You can recover the withheld amount when you file your taxes, but only if you complete the rollover correctly within 60 days. To avoid this issue altogether, request a trustee-to-trustee (direct) rollover.

4. Can I Take Part of My Pension as a Lump Sum and the Rest as Monthly Payments?

Some pension plans allow partial lump sum distributions, where you take part of the benefit upfront and leave the remainder for monthly income. The lump sum portion is still taxable as ordinary income unless rolled over. The remaining monthly payments are taxed as you receive them. Check your plan’s summary plan description to confirm whether partial distributions are permitted.

Bottom Line

A couple working with their financial advisor on their pension lump sum tax calculation and completing a rollover.

Many investors choose to receive a lump sum distribution from their pension to have more control over their money, leave an inheritance or alleviate fears of the pension running out of money. Receiving a lump sum distribution could trigger a large tax bill. To avoid this situation, consider a direct rollover of your lump sum pension distribution to an IRA or another retirement account.

Tips for Creating Retirement Income

Pensions and annuities provide regular income that retirees can depend on. Other investments supplement these payments and grow your portfolio to offset the effects of inflation. SmartAsset’s retirement income calculator can help you determine how much you need to save for retirement.
A financial advisor can help create a financial plan for investment needs and goals. These customized plans factor in the current nest egg, savings rate, risk tolerance and more. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.