Laws and tax rules may change in the future. The way you are taxed also depends on your personal situation and where you reside in the United Kingdom.
Understanding Lump Sum Distributions
A lump sum distribution refers to the distribution of an individual’s entire balance from all qualified retirement plans of one kind (e.g., pension, profit-sharing, or stock bonus plans) within a single tax year. This typically occurs due to:
- Death of the plan participant
- Participant reaching age 59½
- Separation from service (for employees)
- Total and permanent disability (for self-employed individuals)
Tax Treatment Options for Lump Sum Distributions
When receiving a lump sum distribution, you have several options for how the taxable portion will be treated:
1. Capital Gain and Ordinary Income:
- Report the taxable portion from participation before 1974 as a capital gain (if eligible) and the taxable portion from participation after 1973 as ordinary income.
2. Capital Gain and 10-Year Tax Option:
- Report the taxable portion from participation before 1974 as a capital gain (if eligible) and use the 10-year tax option to calculate the tax on the portion from participation after 1973 (if eligible).
3. 10-Year Tax Option:
- Use the 10-year tax option to calculate the tax on the total taxable amount (if eligible).
4. Rollover:
- Roll over all or part of the distribution to an IRA or eligible retirement plan. No tax is currently due on the rolled-over portion. Report any part not rolled over as ordinary income.
5. Ordinary Income:
- Report the entire taxable portion as ordinary income.
Net Unrealized Appreciation (NUA)
If your lump sum distribution includes employer securities and the payer reports an amount in box 6 of your Form 1099-R for NUA, this amount is generally not subject to tax until you sell the securities. However, you can choose to include the NUA in your income in the year the securities are distributed.
Capital Gain Treatment
To receive capital gain treatment, you should receive a Form 1099-R from the payer showing your taxable distribution and the amount eligible for capital gain treatment. If you haven’t received this form by January 31st of the year following the distribution, contact the payer or the IRS for assistance.
Transfer or Rollover Options
You can defer tax on all or part of a lump sum distribution by requesting a direct rollover to an IRA or eligible retirement plan. You can also roll over the taxable amount to an IRA within 60 days after receipt of the distribution. Remember, regular IRA distribution rules will apply to any later distributions, and you cannot use the special tax treatment rules for lump sums.
Mandatory Withholding
Mandatory income tax withholding of 20% applies to most taxable distributions paid directly to you in a lump sum from employer retirement plans, even if you plan to roll over the taxable amount within 60 days. You can choose to have more than 20% withheld by providing the payer with Form W-4R.
Additional Information
For more information on the rules for lump-sum distributions, including information for beneficiaries and alternate payees, distributions that don’t qualify for the 20% capital gain election or the 10-year tax option, and NUA treatment for these distributions, refer to Publication 575, Pension and Annuity Income and the instructions for Form 4972, Tax on Lump-Sum Distributions.
Understanding the various tax treatment options for lump sum distributions is crucial for making informed decisions and maximizing your tax benefits. By carefully considering your options and consulting with a tax professional if needed, you can ensure that your lump sum distribution is handled in the most tax-efficient manner possible.
Good news – you could be eligible to reclaim some tax
When you take your entire pension pot, you will typically receive 20% 25% tax-free 20%E2%80%93%20; however, you will have to pay income tax on the remaining 20%.
If the value of your pot is £10,000 or less, you could withdraw the entire amount at once (i e. you take it as a ‘small pot’). Under these circumstances, stringent government regulations mandate that your provider deduct basic rate tax from the upfront payment.
For certain individuals, paying taxes at the basic rate will be the most appropriate given their circumstances. Depending on your total income for this tax year, some higher earners may be eligible for a tax refund while others may have to pay additional taxes. This covers your pay, any state pension you may receive, any rental income, and the portion of your pension plan payments that are taxable.
Note, however, that these government regulations only apply to small pot payments made in one lump sum.
- Non-taxpayers (generally those with incomes under £12,750): File a P53 on GOV to claim your tax refund if you have taken a “small pot,” which is typically a lump sum pension plan worth no more than £10,000. UK (opens in a new tab) .
- Basic rate taxpayers: Generally speaking, those with incomes between £12,750 and £50,270 have no further tasks to complete as the basic rate tax that they owe has already been deducted.
- higher and additional rate taxpayers (generally income over £50,270) You will be required to pay higher rate or additional rate tax on anything over £50,270 if your earned income plus the taxable portion of the money you are taking out of this pension pot puts you over this threshold. Your provider will deduct basic rate tax for you. The government will get in touch with you at the end of the tax year, or you can pay the additional amount by contacting them. The aforementioned numbers are based on the situation in Wales, England, and Northern Ireland. Different tax bands and rates apply in Scotland. It’s important to keep in mind that the “small pot rules” may not always apply when taking a lump sum payment of £10,000. For instance, you cannot take a fourth personal pension small pot and have the small pot rules apply if you have already taken three of them as lump sums. Put another way, you might be subject to an emergency rate of income tax rather than the standard rate.
This is particularly likely to occur if your provider does not have your most recent tax information.
Claim your tax back:
Check to see if you’re eligible for a tax refund
To find out if you can reclaim tax on your pension lump sums, use our simple and fast tool. Just respond to a maximum of five brief questions, and we’ll let you know what can be done next.
Claiming tax back on Pension withdrawals
Can I claim back tax on a pension lump sum?
You can claim back any tax we owe you on a pension lump sum using P53 if you have taken: You’ll need to use form P53Z instead if: You’ll need to: You can tell us the estimated figures if you do not have final figures. You’ll need to use whole numbers, rounded down to the nearest pound.
Do you pay taxes on a lump sum pension payout?
While you may pay taxes on the conversion, all future earnings and withdrawals are tax-free. Investors can avoid taxes on a lump sum pension payout by rolling over the proceeds into an individual retirement account (IRA) or other eligible retirement accounts. Here are two things you need to know: 20% withholding.
How much of a lump sum pension do you receive?
When that happens, you only receive 80% of your lump-sum distribution. If you want the full amount of your lump sum pension invested in your retirement account, you’ll need to come up with the other 20% yourself. For investors who are able to do so, the 20% that was withheld is returned when you file your taxes.
Are pension distributions taxable?
The Internal Revenue Service (IRS) classifies pension distributions as ordinary income. This means that they are taxed at the highest income tax rates. The agency says that mandatory income tax withholding of 20% applies to the majority of lump sum distributions from employer retirement plans.