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Columns: Tax Talk
George Saenz, CPA   Expert: George Saenz, CPA
Tax Talk
Early pension distribution may be exempt from penalty
Tax Talk

Accounting for an early pension payout

Dear Tax Talk,
In 2002 my wife was laid off from her job. She was 55 years old at the time and she liquidated her 401(k) plan. The IRS later required us to pay a 10 percent early withdrawal penalty. It was my understanding that the early withdrawal penalty is waived in these circumstances. Which position is correct?
-- James

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Dear James,
An early withdrawal penalty generally applies to distributions from retirement plans prior to age 59½. As with all general tax rules there are exceptions.

The IRS relies on the payer of the pension funds in issuing Form 1099-R to determine if an exception to the 10 percent penalty applies. If the payer knows that an exception applies to your early distribution, distribution code 2, 3 or 4 should be shown in box 7 of your Form 1099-R (see Page 7 of the online form) and you do not have to report the distribution on Form 5329.

If an exception applies but distribution code 1 (early distribution, no known exception) is shown in box 7, you must file Form 5329. Enter the taxable amount of the distribution shown in box 2a of your Form 1099-R on line 1 of Form 5329. On line 2, enter the amount that can be excluded and the exception number shown in the Form 5329 instructions. Page 3 of Form 5329 lists exception code 1 as a distribution received in a year that you separated from your employer's service (i.e. quit, dismissed or laid off) in the year that you reached age 55.

If you're dealing with 2002, the IRS has probably already assessed you the penalty and you may already have paid it. In this case the statute of limitations may limit your ability to reopen the matter. You usually have two years from the date that you paid a tax to make a claim for refund. The claim would be done by filing Form 1040X for the year that the IRS assessed the penalty. IRS Publication 556 provides further information on claims for refund.

Bankrate.com's corrections policy-- Posted: July 19, 2007
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