If you received a lump-sum distribution from a qualified retirement plan, or from an annuity or endowment policy you bought from an insurance company, you may have several choices to make that can have a major effect on the tax on your benefits.
First of all, you won't be taxed on any portion of the payment that represents your cost of the plan that is, any premiums you paid or after-tax contributions you made.
Generally, you have these options:
- Roll the payment over into an IRA or another qualified plan (such as a new employer's 401(k) plan, or one established by your own business). The amount that represents your investment in the contract is not eligible for a rollover, however. The plan sponsor will report only the taxable amount in Box 2a of Form 1099-R, and that is the amount you can roll over to an IRA.
- Receive your payment in cash, and don't roll it over. The taxable portion of it will be taxed as ordinary income in the year it is received, unless you are one of the few people who still qualify for any of the special tax treatments (capital gains treatment, or 5- or 10-year averaging). In addition, you may have to pay an extra 10 percent penalty if the distribution was made "prematurely." In any case, 20 percent of your payment will be withheld for income taxes.
If you roll the amount over into an IRA, you can generally avoid current taxation on the lump-sum, and the amount invested in the IRA will build up tax-free. However, you will be taxed at ordinary rates on all withdrawals as you take money out of the IRA, unless you elect to convert the IRA to a Roth IRA.