What Is Lump Sum Pay & How Is It Taxed?

A lump sum payment represents a single, one-time transfer of money, contrasting with a series of smaller, recurring payments. This type of payment delivers the entire agreed-upon amount at once, providing immediate access to a significant sum for various financial objectives.

Instances of Lump Sum Pay

Individuals might receive lump sum payments in various common situations. One frequent instance is severance pay, provided to an employee upon termination of employment to assist during the transition period. Certain bonuses, such as performance-based incentives, holiday bonuses, or signing bonuses, are also often paid as lump sums. These amounts are typically beyond regular salary or wages.

Retirement plan payouts can also take the form of a lump sum, particularly pension buyouts or distributions from 401(k) accounts, where a retiree opts for a single payment instead of periodic annuity payments. Legal settlements, whether from a lawsuit or workers’ compensation, frequently result in a one-time payment to resolve a claim. Additionally, accumulated unused vacation or sick pay, paid out upon an employee’s departure, often constitutes a lump sum.

Tax Treatment of Lump Sum Payments

Lump sum payments are considered taxable income for federal purposes. Most are treated as ordinary income subject to federal income tax withholding, similar to regular wages. For many supplemental wages, including bonuses and severance pay, employers commonly apply a flat 22% federal income tax withholding rate for amounts up to $1 million. If the amount exceeds $1 million, the withholding rate on the excess increases to 37%. Withholding is an estimate, and the actual tax liability is determined when filing a tax return.

Beyond federal income tax, lump sum payments are subject to Social Security and Medicare taxes, collectively known as FICA taxes. For 2025, Social Security tax is 6.2% on earnings up to $176,100, while Medicare tax is 1.45% on all earnings, with no wage base limit. An additional 0.9% Medicare tax may apply to wages exceeding certain thresholds, such as $200,000 for single filers. State income tax implications also apply, with rules and rates varying by state, and some states may have specific taxes on lump sum distributions.

Special tax rules apply to certain types of lump sum payments. Distributions from qualified retirement plans, such as 401(k)s or pensions, are taxable as ordinary income. If a distribution occurs before age 59½, it may be subject to an additional 10% early withdrawal penalty, unless an exception applies. Direct rollovers of these funds to another qualified retirement account can defer taxation and avoid penalties. Legal settlements have specific tax treatments; for instance, damages received for personal physical injuries or physical sickness are excluded from gross income, but punitive damages, interest, and awards for lost wages or emotional distress not tied to physical injury are taxable.

Distinguishing Lump Sums from Regular Pay

Lump sum payments differ from regular, recurring pay in their nature and purpose. Regular pay, such as wages or salary, represents compensation for ongoing work performed over a set period, paid periodically (e.g., weekly, bi-weekly). In contrast, a lump sum is a one-time payment for a specific event or accumulated benefit, not for continuous work. This distinction means regular pay is earned incrementally, while a lump sum is often tied to a past event or a future consideration.

The reporting of these payments on tax forms further illustrates their differences. Regular wages are primarily reported on Form W-2, Wage and Tax Statement, reflecting annual earnings and withholdings. Lump sum payments, depending on their source, might appear on a W-2 if they are supplemental wages, or on other forms like Form 1099-R for retirement distributions. This separate reporting helps to categorize the income for tax purposes, recognizing the distinct financial events they represent.