Tax Penalty for Taking Out Pension Funds
A retirement plan is designed to provide financial security for your future. You put away tax-free money over a period of time and receive periodic payments when your retire. If you decide to take the money before your retirement age, you have to pay taxes and penalties. Certain plans may waive penalties if your withdrawal reason qualifies.
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Early Distribution
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Taking the money out of a retirement plan before turning 59 1/2 years old is called an early distribution. The government imposes a penalty on early distribution to discourage individuals from cashing out their retirement plans when they have a minor financial problem. Other state and federal taxes may apply to the distribution amount. The penalty may be waived in exceptional situations.
Penalty
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You must pay federal and state taxes on the amount you withdraw, because you contribute money into your retirement plan before taxes. An agency that services your retirement plan may take federal taxes out and send it to the government. You may have to pay the state taxes yourself as tax rates vary by state. You have to pay a penalty of 10 percent when you file your tax returns the following tax year if you take an early withdrawal and don't qualify for a penalty waiver.
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Exceptions
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Certain plans allow you to take substantially equal periodic payments from your retirement plan and spread them over your life. This exception is penalty-free and available to anyone regardless of age. If you leave your job when you are at least 55 years of age and take a distribution from your plan, you don't pay an early distribution penalty. If you withdraw the money to pay medical expenses. However, there are restrictions on this distribution. To qualify to an exemption, your medical expenses must exceed 7.5 percent of your adjusted gross income. If you pay qualified college expenses for yourself or a dependent, you don't pay an early withdrawal penalty tax. If you use the money to purchase your first home, the penalty is waived. You also do not pay the penalty if you become disabled or if you are unemployed and use the funds to pay for your health insurance.
Considerations
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Be familiar with your retirement plan details to know what penalties you have to pay if you take an early distribution. You may be able to take a loan against your retirement savings balance to avoid paying a penalty tax. Such loans generally have low interest rates and favorable terms. If you decide to take your retirement savings out early, consult with a financial adviser and put money aside to pay taxes when they come due.
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