Taking 20% Off the Top of Pension Withdrawals

Q: Can you explain the recent Internal Revenue Service ruling on withholding taxes on hardship withdrawals from tax-deferred pension plans? I was completely confused. --A.B.

A: The changes are less sweeping and involve fewer taxpayers than some early news accounts suggested. But they are nevertheless confusing.

Let’s start by laying some groundwork. In July, the federal government extended unemployment benefits for millions of jobless Americans, a move that will cost millions of dollars the government clearly doesn’t have. So Congress tapped a new source of revenue: lump-sum payouts from employer-sponsored pension plans by people quitting or fired from their jobs.

Under the new rules that go into effect Jan. 1, taxpayers electing to cash out of their old employer’s 401(k) or other qualified pension plan, will be slapped with a 20% withholding tax on the disbursement if they take possession of the money rather than have it rolled over directly to a qualified individual retirement account. Even if the taxpayer puts the pension money in an IRA himself within the allowed 60 days, the 20% tax is applied. It is important to note that the new rules do not apply to IRA transfers made within the allowed 60 days or any IRA transactions. The rules apply only to distributions from employer-sponsored pension plans that are eligible for rollover into tax-deferred IRAs.

This new application of withholding tax doesn’t increase Uncle Sam’s overall tax revenue--taxpayers will get the money back when they file their income-tax claims the following year--but it does allow the government to get its hands on some immediate cash. You can consider it sort of a short-term loan from certain taxpayers to their Uncle Sam.

However, it can have some devastating impacts on taxpayers leaving their jobs under less than desirable circumstances. Unless these taxpayers leave their pension money with their former employers or tell their employers to put their lump-sum pension money directly into another IRA, they face a 20% withholding tax on the distribution. Furthermore, if they want to put the entire amount of their distribution into an IRA, they will have to come up with the difference in cash.

Here’s how it would work: Let’s say you are entitled to receive a $100,000 pension distribution. If your employer’s check is made out to you, rather than to an IRA plan administrator, you will get just $80,000. But remember, you are entitled to put $100,000 into a tax-deferred account, and you still can. The only hitch is that you have to come up with the $20,000 (the same money the government took in withholding tax) on your own. To avoid the hit, you must direct your pension plan administrator to put your money directly into a qualified IRA. All it takes is planning to avoid the tax, but you do need to know that the rules have been changed so you can do the necessary advance work.

The issue settled late last month centered on the question of whether this same 20% withholding tax would be applied to hardship withdrawals from 401(k), profit sharing and other employer-sponsored retirement plans. The answer is: yes.

Previously, hardship withdrawals, which must already meet a stringent test to avoid a 10% penalty, were subject to ordinary income taxation. However, the tax bill was settled when the taxpayer filed his income-tax return. Under the latest ruling, Uncle Sam will take his money off the top, leaving the worker, who is already in an economically distressed situation, with 20% less than he had planned to get.

Social Security’s Payouts for Spouses

Q: My wife is entitled to a small Social Security benefit on her own account when she turns age 62 next year. What is she entitled to in spousal benefits if she applies on my account next year? --J.D.S.

A: At age 62, a spouse (husband or wife) is entitled to 37.5% of the benefits the wage earner would have received at age 65. So even if you retire at age 62 with somewhat reduced benefits, your wife’s benefits are computed according to the amount you would have received if you had waited until age 65 to begin drawing them.

If the benefits to which your wife is entitled on her own account are greater than 37.5% of yours, then her payments will be based on her account. No one can get both his or her own benefits plus full spousal benefits. However, the Social Security Administration often confuses taxpayers by saying that a spouse is drawing on both their own account and that of the husband or wife. That is technically true. Once a spouse’s benefit entitlement is set, the Social Security Administration will first draw on that person’s account for payment; the remainder is made up in spousal benefits. The total, no matter where the parts came from, is still the same.

5 Conditions That Determine Tax Status

Q: I have lived with my fiance for the last eight years while working part time making and selling crafts. For the most part, he supports me. Why can’t he claim me as a dependent on his tax return? --C.C.

A: Whether you qualify as your fiance’s dependent entirely hinges on whether you satisfy all five of the Internal Revenue Service conditions.

For starters, you must be a U.S. citizen or resident of the United States, Canada or Mexico. Your fiance must provide the majority of your support. You may not claim your own personal exemption on your tax form. You must be related to or a member of the household with the person claiming you as a deduction for the entire tax year. And finally, your gross annual income cannot exceed the standard deduction amount of $2,150 for 1992. (The income limit does not include Social Security payments and does not apply to a taxpayer’s child under age 19 or a student.)

Can you qualify? It possibly all comes down to the amount of money you make from your part-time job. If it is under the $2,150 limit and you meet the other criteria, your fiance should be able to claim you as a dependent.

EDITOR’S NOTE: In an Oct. 11 column, readers were told they could call the Federal Reserve Bank in Kansas City to get forms related to U.S. Savings Bonds. Fed officials say residents of California, Oregon, Washington, Idaho, Nevada, Utah and Arizona should call (800) 695-BOND. Residents of all other states should call their area Federal Reserve Bank or branch or call their local bank for the numbers.