Lump-Sum Distribution

What Is a Lump-Sum Distribution?

A lump-sum distribution is a one-time lump-sum payment from an amount of money owed to some party, rather than via payments broken into smaller installments. In certain cases, lump-sum distributions may receive special tax treatment. Lump-sum distributions are commonly associated with choosing how to receive windfall earnings, such as from winning the lottery, or from a retirement or pension plan. Lump-sum distributions can be contrasted with annuitized distributions.

How a Lump-Sum Distribution Works

It is not always best to take the lump-sum payment in lieu of periodic annual payments; if offered the choice, consider taxes, investments, and the net present value (NPV), which accounts for the time value of money.

Two common examples of lump-sum distributions are a commission check and a pension plan distribution, following a pensioner’s death.

In general, distributions from qualified plans are treated as lump sums if the total plan balance is distributed over the same tax year, and if the distribution is made as a result of the employee:

Lump-Sum Distribution and Qualified Retirement Plans

If a pension plan owner passes away, a lump-sum distribution will often transfer to a beneficiary or beneficiaries. These can be relatives, close acquaintances, or even institutions such as charities. Beneficiaries can be revocable or irrevocable, have discretionary powers (or not).

Qualified plans generally fall into two categories: defined benefit and defined contribution. Defined benefit plans give employees a guaranteed payout; this places the risk on the employer to save and invest properly to meet plan liabilities. For employees in a defined contribution plan, the amount they receive in retirement depends on how well they save and invest on their own behalf during their working years. A 401(k) is the most popular example of a defined contribution plan.

Other examples of qualified plans that may grant lump-sum distributions include:

The Internal Revenue Service (IRS) provides a comprehensive guide to common qualified plan requirements. This guide breaks down each plan and who they best suit, draws comparisons among them, and notes risks or concerns for potential or current investors.

Commission Check and Qualified Retirement Plans

Commission checks are another example that can be paid out as lump-sum payments. Commission checks apply to roles mainly in sales and marketing either as sole earnings or in addition to a base salary. Employers often use sales commissions to incentivize workers to produce more value. Several major types of commission checks include a base salary and commission, straight commission, draw against commission, and residual commission.

Lump-Sums Versus Annuity Payments

To illustrate how lump-sum and annuity payments work, imagine you won $10 million in the lottery. If you took the entire winnings as a lump-sum payment, the entire winnings would be subject to income tax in that year, and you would be in the highest tax bracket.

However, if you choose the annuity option, the payments could come to you over several decades. For example, instead of $10 million of income in one year, your annuity payment might be $300,000 a year. Although the $300,000 would be subject to income tax, it would likely keep you out of the highest state tax brackets. You would also avoid the highest federal income tax bracket of 37% (as of 2020) for single people with incomes greater than $518,400 or $622,050 for married couples filing jointly.

In 2021, those figures go up. Single people with incomes greater than $523,600 and married couples filing jointly with incomes up to $628,300 are in the 37% tax bracket. Such tax questions depend on the size of the lottery win, current income tax rates, projected income tax rates, your state of residency when you win, in which state you will live after the win, and investment returns. But if you can earn an annual return of more than 3% to 4%, the lump sum option usually makes more sense with a 30-year annuity.

Another big advantage of taking the money over time is that it provides winners with a "do-over" card. By receiving a check every year, winners have a better chance of managing their money properly, even if things go badly the first year.