What will you do with the largest check you will probably ever get in your life? It will come from your company's pension, thrift or profit-sharing plan when you leave your job, and it will settle all accounts between the company and you.
Maybe you don't expect to leave your job right now. But most employes change companies at least once in their lives, which means that everyone who has a pension plan may face this decision, sooner or later.
During the years you work for a company and are covered by its pension plan, benefits build up in your account. As long as you stay at least five to 10 years, those pension benefits are yours to keep--even if you quit your job or are fired.
The longer you stay, the bigger your check when you leave. It is common for pension-plan distributions to run to $50,000 and more for middle-level employes, and well into the six figures for executives.
But that's your total amount, before the tax collector gives your check a haircut. How much you net after taxes depends on how you handle the money.
You have several choices--some triggering higher taxes, some triggering lower taxes--and if you're like most people, your company won't even tell you about them. You have to figure them out yourself, and might mistakenly do exactly the things that will cost the highest tax.
In short, it's the usual mess. It will pay to get help from an accountant in your company or from an independent accountant. Here are the things you can do with a pension distribution:
* The cheapest way to pay taxes is through 10-year income averaging. Under this lovely system, the income is treated as if it were paid in 10 equal, annual installments, and as if you had no other income. A $50,000 pension distribution can be taxed at a mere 12 1/2 percent. A $20,000 distribution can be taxed at 5 1/2 percent.
This is your best choice if you plan to use the money from your pension plan right away--maybe to start another business, or to live on while you find another job. (There are a few conditions applied to 10-year averaging, which you can find in any tax book.)
* The most expensive way to handle the money is to add it to your regular income. Doing so is a flat mistake and causes you to overpay your taxes.
Some taxpayers add the pension distribution to their regular income and then use five-year income averaging to reduce the tax. But that's not the same thing as 10-year averaging and won't save you nearly as much money.
If you, or anyone in your family, has already made this mistake, you can file an amended tax return and get some of your money back.
* If you want to save your pension distribution for retirement, the best plan is to roll it directly into an Individual Retirement Account. You normally can't touch these funds until age 59 1/2 without paying a penalty. When you retire and start drawing on the IRA, you will pay ordinary income taxes on each withdrawal. So in the long run, your taxes will be greater than if you took 10-year averaging.
But the big advantage of the IRA is that all taxes are deferred. You can keep the entire sum of money invested, and earning interest, without taking anything out for taxes until you actually start using the IRA to live on. So in the long run, using an IRA will leave you with more retirement funds.
If you're age 40, an IRA is often the obvious choice. But if you're in your 50s and lost your job, the decision is a lot harder. You have to start an IRA within 60 days of getting the final distribution from the pension plan. "It might take longer than 60 days to find another job, and in the meantime you might need the money," says Richard Cummins, a partner in the accounting firm of Coopers & Lybrand.
You can put part of your money into an IRA and leave part of it in your bank account, ready for use. That gives you one-half of a good thing. You get the tax deferral on the IRA, but you cannot use 10-year averaging on the money you put in the bank account. (But you can use regular, five-year averaging. As I said, these tax questions are a mess.)
* Some companies let you keep your money in the pension plan. If it has a good yield, that may be a tempting thing to do. But at retirement, you will have to expect whatever annuity payments the plan allows. Chances are you will get a better retirement income by switching the money to an IRA at a bank or savings and loan association and controlling the money yourself.