How Retirees Can Treat Pension Payout

QUESTION: My father will retire in a few months and has opted to take a lump-sum payout of his pension that will amount to about $200,000. What steps can be taken to shelter this distribution from immediate taxation? This distribution is a sizable portion of what my parents will be depending on for income during their retirement.--R. M.

ANSWER: Basically, your father has two alternatives for handling his pension distribution. He can put his entire pension distribution into a tax-deferred individual retirement account, or he can pay taxes on it now and probably take advantage of a special income-averaging benefit available to many in his age bracket.

Which choice is best for your father? Torrance financial planner Thomas Gau believes that your father would be far better off rolling the pension account into an IRA. But let’s walk through the situation and explain why.

If your father turned 50 before Jan. 1, 1986, he is eligible to take advantage of a special 10-year income averaging, a tax benefit that essentially treats the $200,000 lump-sum distribution as though it had been received over 10 years. (If he turned 50 after that date, he is entitled to spread the amount over just five years.) Gau estimates that even using the 10-year averaging, your father would be liable for about $50,000 in state and federal taxes for the year in which he received his pension fund, leaving him with $150,000 to invest for retirement. Remember, you are only paying taxes on the principal; earnings from this investment are still taxable.

Gau argues that if your father rolled his pension distribution into an IRA and invested it wisely, he could withdraw whatever he needed from the account and pay taxes only on that amount. Gau notes that many retirees are in a low tax bracket, which means that less of their pension distribution goes to taxes.

As a rule of thumb, Gau says pension distributions in excess of $100,000 should not be subjected to the special 10-year income averaging, but rather should be rolled into IRAs. “Unless you need the money right away for some reason, the 10-year averaging doesn’t make sense for distributions over $100,000,” he says. “Why pay the taxes right away when you can defer it and probably pay less?”

Well-Intended Gift May Be Ill-Advised

Q: About 18 months ago, my mother deeded her home to my two brothers and me, reserving a life estate to herself. She moved into a retirement home. Now she wants to sell the house and take advantage of the one-time exclusion of $125,000 in profits. Before moving into a rest home, my mother had owned and lived in the house for 15 years. Will the IRS construe the deeding of the house to my brothers and me as an interruption in ownership? Do I need a lawyer?--R. A.

A: To take advantage of the special $125,000 profit exemption, a home seller must be over age 55 and have lived in the house three of the last five years. Now, if your mother has been in a rest home for the last 18 months, she has about six months left to take advantage of this tax break. The law makes some exceptions if your mother is living in a licensed nursing care home, but you should consult a tax specialist for details.

But all of this still does not address the question of who owns the house. You should deed the house back to your mother as soon as possible, and to be in compliance with IRS regulations, you and your brothers should file a gift-tax return noting that you gave your mother a gift. (Your mother should also have filed such a return when she deeded the house to you.) If all of this paper work is completed quickly enough for your mother to meet the residency requirements, she should be able to sell the house and take the tax break.

One more general point that our experts repeatedly noted: Your mother’s decision to deed the house to you in the first place was no doubt motivated by a sincere desire to spare you a tax burden upon her death. But giving away appreciated assets, as most homes in California are, is not wise, either from a practical standpoint, as you are discovering, or from a tax perspective.

Upon your mother’s death, the value of her house is immediately set as of the date of her death. If her estate is valued at less than $600,000, you and your two brothers could equally share it without having any estate taxes assessed. Of course, there would still be probate fees. But once you take possession of the assets, you are liable for taxes on any appreciation only from the date of your mother’s death forward. So if her house is valued at her death at $200,000 and she paid $50,000, you and your brothers essentially get $150,000 in tax-free appreciation. However, if you are deeded the house as a gift, its tax basis to you is its original value of $50,000, leaving you liable for taxes on the appreciation. You mother’s original gift, while well intended, was not well advised.

Stock Proceeds Can Be Rolled Over Into IRA

Q: I will be quitting my job soon and will be receiving several thousand shares of company stock as my pension distribution. I intend to sell the shares and roll the proceeds into some mutual funds. But exactly how much can I roll over in this manner? Would it be the value of the stock on the distribution date or the actual net proceeds that I receive from the sale of the shares? Also, may I pay the brokerage fees from my own funds and roll over the gross proceeds from the sale?--A. J. M.

A: First of all, we’re assuming that you intend to roll the proceeds from your stock sale into an individual retirement account trust fund that will invest in mutual funds. Because unless this is your intention, your proceeds will be taxable. And you have just 60 days to open the IRA account after selling the shares.

The law allows you to roll over the entire proceeds from the stock sale into a tax-sheltered IRA, even if the stock appreciates between the time you receive it and finally sell it. So you may shelter the appreciation as well as the principal. If the stock should decline in value between the time you receive it and sell it, you are allowed to open an IRA in an amount equal to the shares on the day you received them. The law also allows you to pay the brokerage fees out of your own pocket, so the full amount of the pension can be put into a tax-sheltered account.