Lump Sum Distributions Before Your Age 59 ½

Lump Sum DistributionOftentimes, especially in the current economic climate we are in, we are either forced or choose to change employers during our working years. Better offers, layoffs, lateral moves or early retirement are but a few reasons to change jobs. If you had a 401(k) in your previous job with contributions that were fully vested (meaning that you own the money) you are faced with the decision of what to do with the funds you re leaving behind in the previous employers plan.

When terminating or changing employment prior to age 591/2, a person often has several options as to what to do with the funds in his or her qualified retirement plan. He or she may choose from the following possible actions:

  • Leave funds in current plan: If the current value exceeds $5,000, there may be some benefit to leaving the funds where they are. They will continue to grow tax-deferred and can be transferred at a later date to a rollover IRA or a new employer’s eligible recipient plan.
  • Take cash in lump sum: This option will require the entire amount (less participant after-tax contributions, if any) to be subject to income taxes in the participant’s current tax bracket. There will be an additional 10% penalty tax for a participant under age 591/2 unless he or she falls under certain exceptions.’ The law requires that 20% of the taxable portion of the distribution be withheld for federal income taxes. (2)
  • Rollover or transfer within 60 days: Individuals who receive a cash, lump-sum distribution have a 60-day period during which funds may be transferred to either a rollover IRA or a new employer’s qualified plan. Because this is a cash distribution, a 20% federal income tax withholding is required. Failure to transfer the funds within the 60-day period will result in the total amount (cash received plus the amount withheld) being added to taxable income for the year. Further, if an individual is under age 591/2 at the time of distribution, the total amount will be subject to the 10% penalty tax on early distributions, unless an exception applies. (1)
  • Make a direct transfer: The distribution can be transferred directly from the original, employer-sponsored qualified plan to another employer plan or to a rollover IRA. Since the participant does not actually receive the funds, there is no 20% withholding.

Potential Problem

However, if the plan withholds 20% for federal income taxes, which cannot be returned until after the tax returns for that year are filed, the participant may have to come up with additional funds to make a full rollover.

For example, assume a. distribution of $100,000 is made directly to a terminating employee. The employer would withhold 20%, or $20, 000, for income tax purposes and the employee would receive only $80, 000 in cash while the employee decides within the 60-day period to roll the fund over into an IRA or a new employer’s qualified plan, then he or she must come up with another $20, 000 to make the full transfer. If the funds are not found to make the full $100, 000 transfer, then the $20, 000 withheld becomes taxable to the employee as ordinary income. If the employee is under age 591/2 when the distribution is made, a 10% penalty tax may also be due unless certain exceptions apply

Possible Solutions

To avoid this potential problem, the participant must make some decisions before the plan administrator prepares the check. If the transfer is made directly to a rollover IRA or a new qualified plan, the 20% is not withheld and the entire amount can be transferred. An alternative might be for the participant to transfer the funds to a rollover IRA, and then elect to receive substantially-equal payments over his or her life expectancy and that of another person, if desired. Consult your planner and tax advisor s to the ramifications of each option available to you, taking into account your age, state of residence and individual situation.

1- Distributions before age 59 1/2 from SIMPLE IRA plans made within the first two years of participation are subject to a 25% penalty, rather than a 10% penalty subject to the usual exceptions. If a premature distribution from a SIMPLE IRA is made after two years of participation, the 10% penalty applies. See IRC Sec. 72(t)(6). SIMPLE IRAs are not subject to the 20% mandatory withholding requirement.
2- State law may differ on both the withholding requirements and the penalties for withdrawals prior to age 59 1/2.
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