Taking a pension lump sum triggers one of the largest taxable events most retirees will ever face. The default outcome if you take the cash: your employer withholds 20% before the check reaches you. The right move in almost every case: request a direct rollover to an IRA and pay nothing in the year of the transfer. Here is how it works and what to watch for.
Direct rollover vs. cash distribution
When you elect a pension lump sum, you have two options: take the cash, or roll it directly into an IRA or qualified retirement plan.
If you take the cash: your plan is required to withhold 20% for federal income taxes before the check arrives. If your lump sum is $400,000, you receive $320,000. That full $400,000 is taxable income in the year you received it. You have 60 days to deposit the full $400,000 (including the $80,000 you did not receive) into a qualifying account to avoid owing tax on it. Most people cannot produce the withheld amount out of pocket, so they end up with a large unplanned tax bill.
If you request a direct rollover: the check goes from your pension plan directly to your IRA. Nothing is withheld. Nothing is taxable in the year of the transfer. The full amount lands in your IRA and continues to grow tax-deferred until you take distributions.
Almost everyone should choose the direct rollover. The only exception is if you have a compelling reason to need immediate cash, and even then you can roll to an IRA and immediately take a distribution, giving you more control over the timing and amount of your taxable income.
Tax treatment once inside an IRA
Once the lump sum is in a traditional IRA, you pay ordinary income tax on distributions as you take them. Required Minimum Distributions begin at age 73. This gives you significant control. In a year when your taxable income is otherwise low, you can take larger IRA withdrawals and pay tax at a lower marginal rate. In a high-income year, take only the minimum. This kind of bracket management is unavailable when the pension simply sends you a monthly check.
The 10% early withdrawal penalty
Pension distributions taken before age 59.5 are subject to a 10% early withdrawal penalty on top of ordinary income tax, unless you qualify for an exception. Key exceptions include separation from service at age 55 or older (for employer plans, not IRAs), substantially equal periodic payments under IRS Section 72(t), total and permanent disability, and qualified domestic relations order distributions to an alternate payee.
Important: if you roll your pension lump sum into an IRA and then withdraw before 59.5, the age-55-separated exception does not apply to the IRA. It only covers direct plan distributions. If you are between 55 and 59.5, think carefully before routing through an IRA if you plan to access funds immediately.
State income taxes
Pension income is taxed differently across states. Some states exempt all pension income. Others tax it like regular income. Your state of residence when you take IRA distributions is the state that taxes them. If you are considering relocating, this is worth modeling before you decide where to retire.
Form 1099-R
Your pension plan will send a Form 1099-R for any year you receive a distribution or complete a rollover. Box 7 contains a distribution code. Code G means a direct rollover with no tax owed. Code 7 means a normal taxable distribution. If you completed a direct rollover, report the 1099-R on your Form 1040 even though no tax is owed. The IRS needs to see it to confirm the rollover was handled correctly.