In nearly every instance, taking an early lump-sum withdrawal from a pension plan has negative tax consequences. However, the impact will differ depending on whether you plan to take a distribution now or whether you plan to do so when leaving your current employer for a new job. Either way, there are numerous issues to consider.
Lump-Sum Tax Consequences
Congress grants pensions tax-deferred status to help you save for retirement. You pay no income tax on the money your employer or you contribute to the plan until you make a withdrawal -- usually upon reaching retirement age. If you take an early withdrawal, however, it will be taxed at the same rate as ordinary income and the Internal Revenue Service will tack on a 10 percent penalty. Here's the kicker: Once you take it out, you can't put it back. Not only will you owe taxes and penalties, you will lose for life the tax-deferred advantages those funds were designed to provide.
If you are faced with a financial emergency and you plan to remain with your current employer for the foreseeable future, you may be able to tap your retirement savings now. In cases that represent an "immediate and heavy" need, the IRS allows an employer to offer an early withdrawal option. If you are considering a request for a hardship withdrawal, check with your employer first to see if it is even an option. Certain medical expenses, costs related to the purchase of your first principal residence, expenses for higher education and some others may qualify for special status. You will still owe income tax, and you may also owe the 10 percent penalty for early withdrawal, but you can limit the withdrawal to only what you need.
For the majority of people changing jobs, rolling over retirement funds into a new employer's plan or into a traditional IRA is preferred to taking a lump-sum withdrawal. There's no dollar limit on how much you can transfer, and no federal income tax is withheld. This is called a direct rollover, as you never actually take possession of the money. With an indirect rollover, your former employer cuts you a check and you have 60 days to complete the rollover before taxes and penalties kick in. However, because you effectively have use of this money until you redeposit it, your former employer is required to withhold 20 percent of your distribution as a hedge against your impending tax liability.
The Stand Pat Option
If you're happy with the performance of your current plan or if you simply need time to explore other options, there's no harm in leaving your money in your old employer's plan. This option may be available if you have a vested balance of at least $5,000. It might be especially beneficial if your new employer offers a similar plan but requires you to work for a certain length of time before being allowed to participate. If you meet the requirements, you can execute a direct rollover from your former employer's plan whenever it suits you.
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