Many people face the decision about what to do with a lump-sum of money from their company’s retirement savings plan years before they reach retirement age. This happens when a company terminates its plan or the person decides to leave the company.

Receiving a lump sum of money from a company retirement plan can be exciting – almost like winning the lottery. The dilemma comes when you have to decide what to do with it.

Save it or spend it?

Since money in retirement savings plans is earmarked for retirement, it is granted certain tax advantages by the IRS. However, if the money is taken out prior to age 59 1/2, specific tax ramifications result. Consequently, it is wise to review all your options before making a decision about what to do with a lump sum distribution from a retirement plan.

If you are about to receive a lump sum distribution from a retirement plan, you can do one of two things:

1. You may ask for a check in the amount of the lump sum distribution. If you elect to receive the distribution in cash, however, the IRS requires your employer to withhold 20 percent of the amount as part of your income tax due on the money. This means, for example, that if you are to receive $20,000 in a lump sum, you will receive a check for $16,000. Then, you must pay the balance of income tax currently due on the distribution at your ordinary income tax rate. In addition, if you are under age 59 1/2 a 10 percent early withdrawal penalty may apply. As in the example, your check for $16,000 would reduce to about $12,400 if you are in the 28 percent tax bracket and under age 59 1/2.

2. Or, you may have your lump sum rolled directly to an IRA account and not pay any taxes until you withdraw the money at retirement. In our example, the full $20,000 lump sum would roll into an IRA and continue to grow tax-deferred. Unfortunately, about 70 percent of people receiving lump sum distributions do not roll them over to an IRA account. By not putting aside this money for their future, they not only lose a large portion of the money available to them, but they are reducing their chances for a financially secure retirement and losing out on an opportunity to accumulate funds tax-deferred, which experts agree is the best way to save for retirement.

An example

Jason and Whitney are both 40 years old and both are due to receive a $10,000 distribution from their company’s retirement plan. Since Jason decides to use his money for a down payment on a Corvette he’s admired for years, he receives a check for $8,000 (the company is required to withhold 20 percent). After adjusting for his tax liability (28 percent on the $10,000 of which 20 percent was already paid) plus an early withdrawal penalty of 10 percent, Jason’s final payment from his retirement savings at work is around $6,200.

On the other hand, Whitney instructed her employer to directly roll her distribution of $10,000 into an IRA. Since taxes are deferred, she is able to invest the entire amount. Assuming her money earns 8 percent annually, by the time Whitney is 65 years old, her savings have grown to $68,485. Provided she continues to earn eight percent annually, this nestegg will provide her a monthly income of $500 for the next 20 years. Even though $500 in today’s dollars probably won’t have the same buying power in 25 years, it still provides Whitney with a more comfortable retirement than Jason’s Corvette.

Why do many people let the IRS take almost half of their retirement savings?

Because many people do not clearly understand the consequences of deciding to keep their retirement plan distribution instead of rolling it over into an IRA. The IRS requires companies to provide employees with a written notice stating the amount of money available, the different alternatives and their tax consequences. Since the decision to be made can tremendously impact a person’s future, the individual must carefully read the information provided and understand it fully. Relying on an investment professional for assistance can help.

Rollover IRA facts

1. If there is a possibility you may work for another employer someday that offers a retirement savings plan, you may want to use an IRA as a temporary place to keep your retirement assets. That way, you preserve your ability to roll your distribution (your Rollover IRA) into a new company plan at a later date.

2. Any non-cash assets that are part of the distribution can be directly rolled into an IRA account. For example, if you receive shares of your employer’s stock, you don’t have to sell them in order to roll them into an IRA.

3. You may take distributions from an IRA account at any time. However, withdrawals before age 59 1/2 are subject to a premature distribution penalty aside from a few exceptions (death, disability, periodic payments defined by the IRS, certain medical and medical insurance expenses, and qualified college expenses).

Your situation

The decision you are about to make is going to have a huge impact on your future. Unlike winning the lottery, receiving a lump sum distribution from a retirement plan brings along with it definite rules and regulations. It is very important to take time and contemplate all choices along with their ramifications. Begin by asking yourself the following:

1. How much income will I need to retire comfortably?

2. Where will the income come from?

3. Will I have to continue working after retirement?

4. What part of my retirement income will other sources like Social Security cover?

Since the rules and regulations governing retirement plans are complex and can frequently change, you should always discuss the situation with experienced investment and tax professionals. Your tax adviser can explain the latest IRS regulations regarding retirement plan distributions and the tax inferences of your choices.

Just as important, however, is depending on an experienced retirement planning professional, someone who is trained specifically in evaluating the current alternatives, assessing your unique situation and suggesting ways to minimize taxes while maximizing return. By depending on the experts, you can be assured of making the correct decision.

Marc A. Pellerin is an associate vice president and investment advisor with Advest Inc. in Lewiston.