Tax Penalty for Early Withdrawal of a Pension

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Pensions and retirement plans help millions of workers prepare for their post-employment years, when income from Social Security and investments may provide only partial support for their customary living style. Although these plans may permit withdrawals before retirement actually occurs, in many cases a penalty will apply.

Pension Account Types

A "qualified" pension plan meets certain guidelines set up by the Employee Retirement Income Security Act of 1974. These plans allow tax deferral on pension earnings, or the deduction of current contributions to the account from taxable income. A non-qualified plan does not meet the ERISA guidelines and does not provide any tax advantages on contributions. "Defined benefit" plans, the traditional company pensions, are funded entirely by the employer. Such a plan determines when and how the employee may draw on the assets; there is no early withdrawal tax penalty.

Early Withdrawals from Qualified Plans

Early withdrawal penalties are a familiar feature of individual retirement accounts, which are qualified plans set up under IRS rules. A 10 percent penalty applies if you withdraw any funds before age 59-1/2, unless the withdrawal is for certain purposes, including medical expenses, to buy a first-time house or for educational costs. This penalty, and the exceptions, also apply to employer-sponsored pension plans such as a 401(k) or retirement plans such as a 403(b), designed for employees of tax-exempt organizations or public schools.

Exceptions to the Early Withdrawal Penalty

Non-IRAs that are also qualified by the IRS allow further exceptions to the agency's early-withdrawal penalty. Dividends from employee stock-ownership arrangements, for example, are excepted from the penalty in these plans, as are payments to a spouse, under a qualified domestic relations order, in a divorce or separation. In addition, for a 401(k) and other non-IRA plans, there's no early-withdrawal penalty if an employee left the employer's service in the year after reaching 55, or for a public safety employee who left service after age 50.

Income Tax Withholding and Non-Qualified Penalties

At the time an employer pays out qualified pension funds, through retirement or for any other reason, the IRS requires 20 percent withholding to cover future income tax liabilities and penalties. To avoid this significant cut in a pension payout, the employee must have the pension administrator transfer the funds directly to an IRA, or another employer-sponsored plan, within 60 days. For non-qualified plans, a 20 percent tax penalty applies only if the plan does not meet a complicated set of IRS guidelines on when and how the employee can draw on the assets.

Regular Pension Plan Payouts

By taking regular payments from a qualified pension, if the plan allows this option, employees can avoid early-withdrawal penalties as well as tax withholding. The amount is figured according to the employee's life expectancy at the time the payments begin. The payments must continue for at least five years and until the employee reaches the age of 59-1/2, whichever comes first. In all scenarios, the distributions are subject to income tax on gains, unless the retirement plan is qualified under the Roth rules that provide for tax-free withdrawals.