Taking Your Lumps: Tax-Smart Ways to Receive a Lump Sum

December 10, 2003

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

Every once in a while, you might have the good fortune to receive an unexpected year-end bonus, gift, settlement or refund. Such a windfall is nice, but typically isn't a life-changing event. More likely, it's a chance to spend a little more or, hopefully, save and invest a little more than you'd planned.

Investing a modest lump sum is relatively straightforward—simply deploy the money along the lines of your long-term, strategic asset allocation.

Occasionally, however, you may face a more significant lump sum. Being familiar with the tax rules can help you decide the best way to accept the money.

Let's go through some of the common sources of larger lump sums.

401(k)s, 403(b)s and other defined contribution retirement plans

If you retire or change jobs, you can roll over your 401(k) balance directly into your traditional IRA or your new employer's 401(k). That way, you continue to enjoy the benefits of tax-deferral.

Taking the money outright means immediate taxation, plus potential penalties, depending on your age. For more on how to plan for a rollover, see What to Do with Your 401(k) when You Change Jobs, or talk to a Schwab Personal Rollover Consultant.

Important: If you’re holding appreciated company stock in your retirement plan, check with your tax professional about the potential benefits of taking your shares directly at retirement rather than rolling them into your IRA. You may be able to pay tax on the cost basis only and defer tax on the appreciation under the Net Unrealized Appreciation (NUA) rules. That way, no matter when you sell the shares, your appreciation would be taxed as a long-term capital gain instead of as ordinary income, which is typically taxed at a higher rate. This could be advantageous, for example, if you need to take distributions in the near future anyway.

Defined benefit pension plans

If you have a more traditional pension plan, it may offer a lump sum payout option. You’ll want to compare the lump sum offered to any available life annuity option. If the lump sum option makes sense, you should be able to roll over the balance to your traditional IRA and continue to defer taxes.

Non-qualified deferred compensation

Non-qualified deferred comp—an “unfunded” promise to pay, subject to the claims of your company’s general creditors—is not eligible for rollover into an IRA. It's generally taxable on receipt, either as a lump sum payment or as annual payments over a term of years. How you decide to take the money will depend on your tax situation and your level of comfort in leaving an unsecured, non-qualified balance with your former employer.

Inheritance

Money you receive through gift or inheritance is free from income tax. In the case of a gift, the donor is responsible for any gift tax liability. And in the case of an inheritance, the deceased’s estate is responsible for any estate tax that might be due.

Life insurance

The same goes for life insurance proceeds—they're income-tax free for the beneficiary. However, the death benefit is included in the taxable estate of the deceased for estate tax purposes if he or she was the policy owner (an irrevocable life insurance trust can solve this problem).

Legal settlement

Generally, amounts received for damages (including punitive damages) are taxable. However, damages related to personal physical injury or sickness are excludable from income. You’ll need to check with a professional about the taxability of a particular lump sum legal settlement, including whether related attorney fees are deductible, etc.

Sale of business

There's no end of complexities here, including calculation of cost basis, the nature of the legal business entity and the structure of the sale. In general, you’re typically looking at a major long-term capital gain, which could be recognized in the year of disposition or over time through an installment sale.

A qualified CPA is a must for structuring the most tax-efficient sales strategy. Remember, long-term capital gain rates are now 15%, but only as long as the sale occurs by Dec. 31, 2008. If an installment sale makes sense, keep the same date in mind—installments received later could be taxed at a higher capital gains rate.

Consider investing the money

Unless your lump sum represents an unexpected, life-changing sum, you’ll probably want to integrate the money into your portfolio along the lines of your long-term, strategic asset allocation—either all at once or over time using a dollar-cost-averaging approach. Extremely large lump sums, however, may require special planning. For more, see What to Do if You Receive A REALLY BIG Windfall.