If you’re retiring, taking a position with a new employer, or have decided to leave your job for a wide variety of other reasons, you’re faced with a major financial decision: What should you do with the money in your retirement plan?
One option is taking your savings as a lump-sum distribution, and not investing them in another tax-deferred plan. If you need cash immediately, this will certainly work. Some investors’ do just this, reasoning that it’s better to pay taxes now rather than later.
Major tax ramifications
But if you take your savings as a lump-sum distribution and don’t invest them in another tax-deferred plan, you’ll pay the price: Uncle Sam is waiting to take your money. Twenty percent of your savings will be withheld immediately to pay federal income tax, and you’ll have to pay any remaining federal tax, as well as state and local taxes, when you file your annual income tax return.
Additionally, if you’re under age 59½, you may be subject to a 10 percent early-withdrawal penalty. Then, whatever is left won’t continue to grow tax-deferred.
Hypothetical example: $112,803 versus $181,940
For example: Let’s say you decide to take $100,000 as a lump-sum distribution and invest it in a non-tax-deferred investment. You pay a $10,000 early-withdrawal penalty and (if you’re in the 28 percent tax bracket) another $28,000 in federal taxes. That leaves you with just $62,000 to invest. Assuming an investment return of 6 percent compounded monthly, you would have $112,803 in 10 years.
But, if you keep the $100,000 in a tax-deferred plan, and the money grows at the same 6 percent compounded monthly, you’d have $181,940 in 10 years, significantly more than if you had taken a lump-sum distribution and paid taxes.
Of course, these examples are hypothetical; please consult your advisor for help in determining the course of action that’s best for you.