Pension or retirement lump sums are taxable unless they are rolled over into a traditional IRA or qualified retirement plan, reports the IRS. Taxable portions of lump sum distributions include the portion the employer contributed and earned profits from the account. Nondeductible employee costs in the lump sum are tax-free.
If the pension or retirement account administrator rolls the lump sum directly into another IRA or retirement plan, the distribution is tax-free, and the amount is taxable upon distribution from the new account, according to the IRS. However, if the employee personally receives the lump sum and within 60 days rolls over the taxable amount, although the rolled-over amount is not taxed at the time, the employer must withhold a mandatory 20 percent for income tax. Once the funds are transferred to an IRA, the employee can withdraw funds upon retiring at age 55 or later or initiate withdrawal of the funds earlier through periodic payments.
Lump sum distributions that are not rolled over are subject to federal income tax on the taxable portions plus a 10 percent early withdrawal penalty tax if the employee is younger than 55 when leaving work, reports Kiplinger. Even if the employee is old enough not to incur the penalty tax, receiving a pension payout as a lump sum incurs a large federal income tax bill all at once, according to Bankrate.