Ten Percent Penalty

If you receive a lump-sum pension distribution under conditions that the IRS considers "premature," you may be subject to a 10 percent excise tax penalty, in addition to the ordinary income tax on the amount. You can generally avoid this tax by rolling over the entire amount into an IRA and leaving it there; just remember that nearly identical penalties apply for premature distributions from IRAs.

As a general rule, a 10 percent penalty applies for taking a lump-sum distribution before age 59-1/2. A higher penalty (25 percent) applies for taking a distribution from a SIMPLE plan within the first two years of participation. Your 1099-R should show a distribution code of "S" in Box 7 if this 25 percent rate applies.

Exceptions for all plan types. The 10 percent penalty does not apply to qualified plans or IRAs if the distributions are:

• made to a beneficiary or the estate of the plan participant on or after the participant's death
• made because you are totally and permanently disabled
• made as part of a series of substantially equal periodic payments, at least annually, over your life (or life expectancy) or the joint lives (or expectancies) of you and your beneficiary; if from a qualified employee plan, benefits must start after separation from service

Work Smart If you want to take advantage of this last exception, talk to your financial planner about setting up a series of equal payments. There are a number of ways to calculate the payments that are acceptable to the IRS, and your choice among them should depend on things like the size of your lump sum and whether you need more or less cash from the plan each year. However, once you set up a method, you must stick with it. If you deviate from your chosen method before the end of five years or your attainment of age 59-1/2 (whichever takes longer), for any reason other than death or disability, you'll generally have to pay a recapture tax, plus interest, on all distributions received thus far.

Exceptions for IRAs. See also our discussion on premature distributions from IRAs and some special exceptions that can apply.

Exceptions for qualified retirement plans. The 10 percent penalty does not apply to qualified plans if the distributions are:

• made to you after you separated from service if the separation occurred during or after the calendar year in which you reached age 55
• paid to alternate payees (such as a divorced spouse) under a qualified domestic relations order (QDRO)
• not more than your deductible medical expenses (those over 7-1/2 percent of your AGI), whether or not you itemized deductions in 2011
• dividend distributions from an employer's securities held in an employees' trust or annuity plan
• due to an IRS levy
• made to correct excess deferrals, excess contributions, or excess aggregate contributions

Exceptions for nonqualified annuities. The 10 percent penalty does not apply to payments from deferred annuity contracts not purchased by qualified employer plans (i.e., deferred annuities you purchased from a commercial provider) if the payments are:

• allocable to investment in a deferred annuity contract before August 14, 1982
• from an annuity contract under a qualified personal injury settlement
• made under an immediate annuity contract
• made under a deferred annuity contract purchased by your employer at the termination of a qualified retirement plan or qualified annuity that is held by your employer until you separate from service

Reporting the excise tax. If you owe only the extra 10 percent tax on premature distributions, and distribution code 1 is shown in Box 7 of your 1099-R, you can simply enter 10 percent of your taxable distribution on Line 58 of Form 1040. Write "no" on the dotted line next to Line 58 to show that you don't have to file Form 5329.

Otherwise, you must complete Form 5329, Additional Taxes Attributable to IRAs, Other Qualified Retirement Plans Annuities, Modified Endowment Contracts, and MSAs and attach it to your tax return. This form is also required if you meet an exception to the tax but your 1099-R form does not show distribution code 2, 3, or 4 in Box 7, or the code is incorrect.