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Stephen G.
Stephen G., Sr Income Tax Expert
Category: Tax
Satisfied Customers: 4182
Experience:  Extensive Experience with Tax, Financial & Estate Issues
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I live in Oregon. My wife is unable to continue working due

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I live in Oregon. My wife is unable to continue working due to clinical depression and fibromyalgia. She has been with her company 15 years and has a fully vested Pension Equity Plan in the amount of $45k. According to her company policy, she is able to take this money with her upon termination of her employment with the company--either as a rollover into another retirement account or as a lump sum pay out. In July she began receiving temporary disability payments through her company's third party insurer (USAbleLife). The temporary disability ran out in October and the insurer is processing her claim for long term disability. She is working on Social Security Disability paperwork but we don't expect for her to be approved by the government for this for quite some time.

Is there any way around the 10% tax penalty for taking this pension in a lump sum pay out? I am currently unemployed and studying for my real estate license, with the long-term goal of supporting us just on my income. If we take the lump sum payout, our income for this year will still be a bit less than what we made in years past with both of us working full time (our household income last year before taxes was $85k).

If it comes down to it, I think it's worth paying the 10% tax penalty on the $45k, which would still allow us to walk away with $40,500. This would give us a lot of breathing room to get my real estate business going while also continuing to put food on the table.

Given our situation, is there anything I'm missing, and does it sound like we're making a good decision on this?
Submitted: 1 year ago.
Category: Tax
Expert:  Stephen G. replied 1 year ago.

Stephen G. :

Hello, my name isXXXXX & I'll be helping you today. My goal is to give you a complete & accurate answer that you can understand.

Stephen G. :

There's something you are missing; the 10% penalty is in addition to paying regular income tax on the pension plan proceeds.

Customer:

I thought the regular income tax would be based on the pension proceeds PLUS what we made this year in work income, and then there was also to be a 10% tax on the pension amount itself. Is that not how it is applied?

Stephen G. :

How old is your wife?

Customer:

36

Customer:

We've got the disability paper trail going, but that's a long process.

Stephen G. :

The only exception to the 10% penalty that your wife may qualify for would be if she was deemed to be permanently and totally disabled.

Customer:

Ok, that's about what I figured based on some quick research.

Stephen G. :

I was responding to your figure of $40,500., which would consider the 10% penalty only. What about the income tax?

Customer:

If the income tax part is simply that we add the $40,500 to our taxable income, it would keep us in the same tax bracket as last year when we BOTH worked full time and earned a household income of $85k before taxes.

Stephen G. :

It wouldn't be the $40,500. it would be $45,000. & the bracket doesn't tell the whole story; you would still have to pay the tax, so you wouldn't net anywhere near $40,500.

Customer:

$45k - 10% = $40,500

Customer:

oops, not done therre

Stephen G. :

Also, are you receiving unemployment compensation?

Customer:

no

Stephen G. :

What about the income tax?

Stephen G. :

on the $45,000.?

Customer:

The way I had it figured, we would indeed be paying income tax on the $45k, but wouldn't that be done by adding the $45k to our work income for total taxable income? I realize we would lose at least $4,500 due to the 10% penalty. As long as the 10% penalty isn't applied to our TOTAL annual taxable income, I think it would be worth taking the lump sum. Even if we only netted $20k or so from the lump sum it would be a lot of help when we need it most.

Customer:

Our total taxable income for the year still won't be more than $85k, which is what we were used to having as taxable income (minus standard deductions) in years past.

Stephen G. :

Well, it should be more than 20K, but don't forget your Oregon tax also.

Customer:

Also, when both of us were working, we declared zero deductions during the year and during tax time declared our actual deductions.

Customer:

Yep, good old OR income tax. At least there isn't a sales tax

Customer:

Is the income tax on the $45k figured at time of pay out or during tax time?

Stephen G. :

Sure, but apparently you had W2 income & had income tax withholding; with the pension withdrawal you'll have lump sums of tax to pay; so between the Federal & Oregon & the Federal penalty, you could easily have to pay $15,000. - $17,500. + - out of the $45,000.

Stephen G. :

That's a big chunk out of your wife's retirement fund.

Customer:

We don't figure she's going to return to the workforce, at least not anytime soon, so our retirement is going to completely be my job. Also I'm working on getting a good life insurance policy.

Customer:

So the penalty tax and income taxes would come out of the pension pay out immediately then?

Stephen G. :

If you find it absolutely necessary to use those funds, you should at least wait until 2014 to make the withdrawal, which will push the taxes off until next year, when your income is lower.

Stephen G. :

No. It depends upon when you make the withdrawal & exactly what type of pension plan your wife has; there are different income tax withholding rules based upon the particular plan.

Customer:

Ok, got it. Yeah, I'm not sure of the withholding rules for a Pension Equity Plan. So, if we opt to try and withdraw the funds after January 1, 2014, then in the meantime she will have to roll over the pension into another retirement plan. Which types would allow for her to withdraw the funds (of course, penalties still apply)?

Stephen G. :

The only type of plan she can use would be an IRA, since she's unemployed. In the case of IRAs you can elect not to have withholding, but that just puts off the payment of the tax & penalty.

Customer:

She hasn't officially been severed from the company yet, but it's coming soon. Which IRA would be better, Roth or Traditional? Our situation right now is that we need cash to help get us through the loss of income. And you made a great point about next year being a much lower income year for us. So if we could figure a way to get as much cash out of the pension/IRA now and defer til next tax year I think that would work best for us.

Stephen G. :

When you rollover her pension plan to an IRA, she should go to wherever she is going to establish the IRA & have them contact her plan directly and do a "Trustee to Trustee" rollover. That's the only way you can avoid her plan from withholding the tax on her retirement distribution. YOU CAN NOT HAVE THE CHECK SENT DIRECTLY TO YOUR WIFE. If that were to happen, the plan will withhold the taxes, then if you want to rollover the funds, you will have to come up with the amount withheld from another source (which you many not have) or you won't be able to rollover the entire balance (as the check she receives will be the net amount, less the withholding).

Stephen G. :

You can't establish a Roth without paying the income tax & penalty, so you don't want to do that.

Stephen G. :

Since you are probably going to have to use the money after you roll it over, you will want to invest the funds for safety, so a bank IRA will probably be the best way to go, with the money invested in a money market or a short-term CD even though they don't pay very much as you are going to want to be able to get your hands on the funds when you need them.

Stephen G. :

I'll leave my contact information here in case you need to contact me again here at JustAnswer.com for any other tax or financial questions.

Stephen G. :

If you want to contact me again with any tax or financial questions, you can just ask for "Steve G" at the beginning of your question. Thanks again for using us for your tax and financial questions. You may get a short survey from the site; if it isn't too much trouble I would appreciate it if you would answer it; the survey results are used by the site as an additional tool to rate our performance;

Please remember to rate my response; it is the only way we get credit for our work.

Stephen G. :

Any other questions?

Customer:

Do the federal rules for withdrawals/penalties also automatically apply to employer-sponsored pensions? My wife seems to think that her soon-to-be former employer could decide to grant her a hardship exception. I'm skeptical of that.

Stephen G. :

Yes, a hardship exemption can be granted by the PLAN, not the employer although the Plan Trustees may also be the Owners of the Company.

Customer:

Oh, interesting. So it might be better if we can get the Plan trustees to grant her a hardship exception, but still wait til after Jan 1 to do the withdrawal...?

Stephen G. :

The nature & actual terms of the plan determine whether or not a hardship exemption is even available; they are most often available in 401-K plans as an example (which is why I asked you what type of plan she had). The name you gave me doesn't identify which IRC Code Section her plan was formed under.

Customer:

Got it. So it sounds like the smartest thing to do is for my wife to find out if the Plan trustees will do the hardship exception, and then move forward based on that information.

Stephen G. :

Besides, you may not need a hardship distribution as she is terminating her employment. The hardship distribution won't save you any taxes anyway & if her plan is a 401-K plan, only her contributions can qualify for a hardship exemption. The best course of action is still probably a direct Trustee to Trustee rollover to an IRA followed by any necessary withdrawals in 2014.

Customer:

Ok, thanks. I'll start looking around at options for Traditional IRA's. Thanks a lot for your help!

Stephen G. :

OK, good luck, please remember to rate my response.

Stephen G., Sr Income Tax Expert
Category: Tax
Satisfied Customers: 4182
Experience: Extensive Experience with Tax, Financial & Estate Issues
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Stephen G.
Stephen G.
Sr Financial & Tax Consultant
3648 Satisfied Customers
Extensive Experience with Tax, Financial & Estate Issues