Expert: Allen - 1/11/2010

Question
QUESTION: I am 58 years old and quit my job due to injury. I have only $4000.00 in my pension plan. If I cash out they will deduct 20% for taxes. My question is can I file a tax return and get those taxes refunded? I am on Social Security Disability so I don't have any taxable income.

ANSWER: Sorry to hear of your situation.

Unfortunately the plan administrator must deduct the 20% for federal income tax. This is a legal requirement. The taxes will be refunded when you file your 2010 tax return next year. Worse yet if you live in certain states, the administrator will have to deduct an amount for potential state taxes. If this is done, you will get a refund when you file your 2010 state tax return.

Even though you may not ultimately be liable for income taxes, you may have to pay a 10% excise tax for receiving money before age 59 1/2. This is not deducted from your payment. It's due when you file your 2010 federal tax return. This tax does not apply if the distribution is due to disability. So you will want to verify that when the distribution is reported to the IRS next January, that the form will be coded to show that the distribution was on account of disability.

One way to get around the automatic 20% withholding is to have the distribution rolled to an IRA. You can then take the money from the IRA and no tax will be withhold. If your total taxable income from all sources in 2010 was high enough, taxes will be due when you file your 2010 tax return. The problem with this approach is that the 10% excise tax (which is independent of your taxable income) will be due if the distribution from the IRA is made before you are 59 1/2 or if the distribution was not on account of disability. It may be harder to get the distribution form that is sent to the IRS coded to show it was on account of disability when it comes from the IRA rather than a pension plan.

Hope this isn't too confusing.

---------- FOLLOW-UP ----------

QUESTION: Thank you for your response. I live in the state of California so state taxes will be deducted. I will be 59 1/2 at the end of this October. I am thinking I should leave my money in the pension fund until them and then cash it out and claim it on my 2010 income tax to get a full refund. What do you think?

Answer
You will definitely avoids the penalty tax if you wait until November to take the distribution. Unfortunately, the trustee will have to withhold federal and state income tax. You will get the taxes back when you file your tax returns for 2010. The IRA route with distribution after October will avoid withholding of income tax.