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Question for the Money Doctors

Question submitted on Jun 3, 2021.

Question

I am under 55 and have been with my company for 21+ years. I have a defined benefit pension with my company as well as a 401k. I am fully vested in both plans. My question is, how much tax will I pay if I retire now and withdrawal the lump sum (approx 600K) of my defined benefit pension? Thank you.

Answer

It’s not often anymore you see an employee with so many years of service with the same employer, so congratulations. The answer to your question depends on a few factors, so we present the following questions for you to consider:

  1. Does your Plan allow for an early withdrawal, or do you need to reach full retirement age as defined by the Plan (and what is that age)?
  2. Are you thinking of taking the amount as a one-time distribution, or would you be rolling the lump sum to an IRA?  
  3. Are all the assets in both your defined benefit pension and your 401(k) pre-tax or is there a Roth or after-tax component of the 401(k)?
  4. Do you intend to work part time after you leave your current employer?

We ask the first question because your Plan(s) may require you to reach the Plans’ definition of full retirement age in order to withdraw, or you may need to meet a minimum service requirement, or both. Assuming the answer is “yes” and that you are allowed to take an early withdrawal, you have two options:

  1. Withdraw the $600k as a distribution, and you will be subject to a federal tax depending on your tax bracket.   For 2021, the highest federal tax bracket (taxable income over $523,600 for single individuals and $628,300 for married filing jointly) has a 37% tax rate.  Additionally, depending on the state you live in, you could be subject to state income tax on the distribution.   Lastly, you could have a 10% penalty on the distribution if you are not eligible for an early withdrawal per your Plan document and / or an IRA should you roll over to an IRA first.  This is generally speaking not a recommended approach.
  2. Do a direct rollover of the lump sum to an IRA. There would be no tax consequence to that transaction.  Future withdrawals from the IRA are subject to Federal and State taxation but can be managed with the right strategies.  We encourage you to work with a local CPA/PFS to help determine an optimization strategy for your cash flow needs looking forward to retirement.

If any of the assets in either your defined benefit pension or your 401k have Roth or after-tax components, then that would reduce the amount taxed on your withdrawal as they were already subject to tax. However, if all the assets are pre-tax, then any withdrawal with be treated as ordinary income as described above.  Roth and After-tax 401k components can be rolled over to Roth IRA or after-tax accounts, accordingly.

Lastly, you want to consider your future cash flow needs. If you retire at 55, there will be a gap in income until you can collect social security (if you decide to collect the reduced amount) at age 62.  If you are considering working a part time job after you retire from your current employer, that would be a source of income that could support your cash flow needs.  We would again recommend you reach out to a CPA/PFS in your area to help you manage all your assets in the coming years, and assist you in determining your optimal cash flow, planning and tax strategy.  Visit www.aicpa.org/findacpapfs to find a CPA/PFS near you.


For additional information visit //www.360financialliteracy.org/

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