What are the tax implications of taking a lump-sum distribution from a defined benefit pension plan instead of rolling it over in 2025?

Taking a lump-sum distribution from a defined benefit pension plan (like a traditional pension or defined benefit 401(k)) instead of rolling it over directly into an IRA or another qualified plan has significant and often immediate negative tax consequences in 2025. The main goal when receiving such a distribution is usually to avoid immediate taxation and the 10% early withdrawal penalty, which a direct rollover achieves.

### Immediate Taxation and Penalty

If you receive the lump-sum distribution directly (a 'cashout') rather than having it rolled over by the plan administrator or within 60 days yourself, the entire taxable portion of the distribution is included in your gross income for the year you receive it. Furthermore, if you are under age 59½, the distribution is generally subject to an additional 10% early withdrawal penalty.

Tax Treatment:

• Pre-Tax Contributions: All employer contributions and deductible employee contributions, plus any earnings, are taxed as ordinary income.
• After-Tax Contributions (Basis): Any portion of the distribution that represents after-tax employee contributions (your basis) is returned tax-free, but you must be able to prove the amount.

### Optional Withholding

If the plan administrator sends the distribution directly to you, they are generally required to withhold 20% federal income tax from the distribution amount. This mandatory withholding does not eliminate your overall tax liability; it is simply an advance payment toward your total tax bill for the year. If you fail to deposit the full amount of the distribution (including the 20% withheld) into an IRA within 60 days, the portion not rolled over becomes taxable and subject to the 10% penalty if you are under 59½.

### Avoiding the Penalty and Tax (The Rollover)

The primary method to avoid immediate taxation and the 10% penalty is to execute a direct rollover or a 60-day rollover into an Eligible Retirement Account (IRA or another employer plan).

• Direct Rollover: The funds are transferred directly from the pension plan trustee to the receiving IRA trustee. This avoids all withholding and immediate tax consequences.
• 60-Day Rollover: The plan issues the check payable to you, and you must deposit the full gross amount (not just the 80% remaining after withholding) into the new IRA within 60 days. If you deposit the net amount (after 20% withholding), the 20% shortfall is treated as a taxable distribution subject to income tax and potential penalties.

### Special Rule: Rollover of Pension Distributions

For distributions from defined benefit plans, special rules apply regarding the 10% penalty if the participant is age 50 or older in the year of separation from service. This is known as the Rule of 55.

If you cash out the lump sum, you will report the taxable amount on Form 1040, and if you are under 59½, you must also file Form 5325 to calculate the 10% penalty, unless an exception applies.

For further detail, taxpayers should consult IRS Publication 575, Pension and Annuity Income.