A lump-sum distribution refers to the entire amount of an investment being withdrawn from the account in which it is held. This is in contrast to a fixed-period payout or a partial distribution.
In this article, we will examine the tax consequences of lump-sum distributions from several popular investment account types, including those used for retirement planning.
Lump-Sum Distribution from a Traditional IRA
Contributions to a traditional IRA are tax-deductible in the year they are made, and taxes on earnings – including dividends and interest held in the IRA – are deferred until withdrawn. In exchange for this favorable tax treatment, any distribution from a traditional individual retirement account (IRA) will be fully taxable.
A lump-sum distribution from a traditional IRA will be taxed at the investor’s top marginal income tax rate. In addition to this income tax, distributions taken before age 59½ are subject to a 10% IRS tax penalty.
Lump-Sum Distribution from a Roth IRA
Roth IRAs are retirement planning vehicles that offer no tax deductibility for contributions, but the tax benefits on these accounts are found on the back end, so to speak.
Contributions to a Roth IRA, plus any associated earnings, may be withdrawn completely tax-free under a couple of conditions. Firstly, as with a traditional IRA, the investor must be over age 59½ to avoid the 10% tax penalty. Secondly, the contribution must have remained in the account for at least five years before it qualifies for tax-free treatment.
To sum up, under the right circumstances, a lump-sum distribution from a Roth IRA can be completely tax-free.
Lump-Sum Distribution from an Annuity
An annuity may be set up as a non-qualified account, a traditional IRA, or a Roth IRA.
In a non-qualified annuity, the investment in the annuity has already been taxed.
When taking a lump sum distribution from a non-qualified annuity, the gains in the account are taxed at the annuity owner’s top marginal income tax rate.
Lump-sum distributions work in the same way as with other traditional IRA’s; they are fully taxable at the annuity owner’s top marginal income tax rate.
The same rules apply to Roth IRA annuities as to other Roth IRAs; lump-sum distributions can be tax-free under the right circumstances.
For all annuities, the 10% tax penalty for withdrawals prior to age 59½ applies.
Lump-Sum Distribution from a Taxable Brokerage Account
In a taxable brokerage account, the tax consequences of capital gains and losses happen in the year these events are realized.
For instance, if a security is sold at a profit, taxes are due on the gain in the year the sale occurs. The amount of tax due will depend on whether the gain was long-term or short-term.
If a security is sold at a loss, then the amount of the loss may be deducted from taxable income in the year of the sale. Like capital gains, capital losses are taxed according to the term of the period for which the security was held.
Whether a lump-sum distribution is taken or the money is kept in the account has no bearing on the tax treatment of capital gains and losses.