Employers in the U.S. offer a variety of pension plans to employees that include both defined contribution plans and defined benefit plans. When you cash in your employer-sponsored retirement plan, you have to contend with tax penalties as well as possible penalties that your employer imposes as part of your retirement plan.
Many companies only start making contributions on your behalf to defined benefit plans if you have been with the company for a certain number of years. Such plans often take the form of annuities, and the insurance company that operates the plan guarantees you a certain level of future monthly income based upon the number of payments made to the plan.
If you leave your employer prior to retirement age as defined by the plan, you do not get all of the money you would have received if you had stayed with your employer until retirement age. Instead, you typically receive a lump sum payment that at best amounts to the contributions your employer made to the account on your behalf.
Many companies offer 401(k)s and similar defined-contribution plans into which you and your employer can both contribute money. The money you contribute belongs to you, but your employer's contributions are often subject to a vesting schedule. In a vesting schedule, your employer's contributions gradually become yours over the course of time. Under federal law, your employer can stretch out the vesting so that none of your employer's contributions become yours until two years after the deposit date and it takes six years before all the contributions become yours. If you leave your job, you lose the funds that have not yet been vested.
Under federal tax law, you must pay a 10 percent tax penalty if you withdraw funds from a 401(k) or a defined-benefit plan before you reach the age of 59 1/2. You pay this penalty tax in addition to paying income tax on the entire amount of your withdrawal. Many states have an income tax, in which case you also have to pay state income tax on your withdrawal. Taking your pension as a lump sum could push you into a higher tax bracket.
Companies that have 100 or fewer employees can establish defined contribution plans for their employees that are called SIMPLE IRAs. As with a 401(k), you can make contributions into your SIMPLE IRA in addition to your employer's contributions. If you cash in your SIMPLE IRA, you must pay federal and state income tax on the entire amount you receive. If you are under 59 1/2 and held the account for less than two years, then you must also pay a 25 percent tax penalty. This penalty drops to 10 percent if you held the account for more than two years.