Dear Taxguru,

I had to make a withdrawal from my pension plan. Unfortunately, due to cashflow problems i could not repay the loan in a timely manner.

First question, how much is my projected liability on $25,000 premature pension distribution if I am in the 20% tax bracket?

Second question, is there are any way to legally AVOID this tax liability?

Thanks for your reply.

Dear Lawrence,

Taking a premature distribution from your pension plan is a very costly venture!

Firstly you are subjected to a 10% early withdrawal penalty. This is a penalty imposed by the IRS for taking a distribution prior to age 59 1/2!

Secondly, the entire distribution is generally taxable to you at your applicable tax rate. In fact, I noticed that you mention that your tax rate is 20%. But, depending on the amount of this early distribution, this could potentially put into a higher tax bracket.

So, it seems that your minimum tax would be at least 30% given your current tax circumstances.

Now, to answer your other question! Is there a legal way around, that would enable you to save these additional taxes. The only tax that can be avoided is the penalty, the regular tax is going to be imposed regardless of your situation.

The IRS has identified some hardship situations that would allow you to avoid paying the 10% early withdrawal penalty. The main conditions are that you face a financial hardship and you don't have another source for the cash, that is your savings are non-existent. Here are some situations for which the IRS does not impose early withdrawal penalty.

1. To avoid an eviction notice.

2. Medical reasons necessitating funds.

3. You are disabled.

4, To pay for a down payment on a home.

5. The money is being paid out pursuant to divorce or legal separation.

6. The distribution is made due to an IRS levy of the plan.

7. The payments are made in equal installments over your life expectancy or the life expectancy of you and your beneficiary.

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