taxes on cashout of DB plan

[Josiecat22222]

Ok- quick question--

Just found out from an old employer I have a small (roughly 20K) DB plan which they are retiring.  If I cash it out, they will withhold 20% for income tax and an additional 10% as I am not 59.5.  If I have no other earned income this year (we are FIREd), does that 20% get paid back as part of my standard deduction when I file my taxes?

[Morning Glory]

You can roll it over to a traditional account with no tax or penalty,  or a Roth account and pay just the tax.

[Josiecat22222]

@Morning Glory - Thank you for your comment; I am aware of these options.  My question specifically is that I have no other W2 or "pretax" income.  Does a cashout of a DB plan or "pension" take up the space for MFJ standard deduction of 24.5K and thus will those taxes be credited back leaving only the 10% penalty for being under 59.5?

We are FIREd.  I am currently cashing out investments to fund our lifestyle.  If I can have this "pretax money" at only a 10% penalty then it is the lowest tax option on the field. 

paging @seattlecyclone, @secondcor521, and @MDM for their wisdom....

[reeshau]

The 20% withholding represents a simple approximation on their part for taxes.  It is not the statutory tax rate on withdrawals.  That will be your tax rate.  If you largely have long-term capital gains, and are under $80,000 or so, that may be 0%, or close to it.  If their withholding is more than your tax liability when you file, then yes you will get a refund.

It is the same math, as if you just took a withdrawal from a traditional 401k or IRA.

For that reason, I'm with Morning Glory:  roll it over, and control the amount and timing you face this math.  Don't give the government an interest-free loan of your withholding.  Do the math first, then take out what you need to come out even--or close to it.

In addition to taxes, this will add to your income for ACA subsidy purposes, of course.  That is an additional tax of taking on a lump sum, and may tilt the math.

[seattlecyclone]

Yeah I'm not 100% sure on this, but I think this would be taxed at your regular marginal rate plus 10% for the early withdrawal if you take it out as cash.

Curious how that would be your lowest-tax option. You say you're cashing out investments...would this be from a taxable account where you pay capital gains tax? If you're still in the 0% bracket for those then that would seem to be an obvious winner for keeping this year's taxes low. If you're not, this DB cashout would not only cost you the 10% early withdrawal tax, but it would also push an equivalent amount of your existing capital gains into the 15% bracket, which would essentially make this transaction be taxed at 25%.

[Josiecat22222]

@seattlecyclone - my investments that I cash out are from post tax funds. I have been doing roth conversions up to the standard deduction annually to use that tax free space. My investments are all long term growth. I hope this clarifies the question.  If not please let me know

[seattlecyclone]

So why not just roll this DB plan into your existing IRA and continue with what you've already been doing with Roth conversions? You'd save 10% this way.

[MDM]

So why not just roll this DB plan into your existing IRA and continue with what you've already been doing with Roth conversions? You'd save 10% this way.

+1

That seems the best approach.

[secondcor521]

Thanks for the ping, Josiecat!  I'm flattered that people think I know stuff about taxes.

My reply is going to match up with the others, but I'm going to focus on your question vs. theirs.  (Their questions are good ones, BTW, but you don't owe me an answer on them.)

A pension cash out is, I'm fairly certain but not completely certain, treated as ordinary income, plus the 10% penalty if you're under 59.5.

Taxwise, the way it works is your pension cash out and Roth conversions are going to be stacked first, then your net capital gains from selling your investments stacks on top of those.  Then your standard (or itemized) deduction gets removed from the bottom of the stack.  Then the tax brackets are applied to what's left; first the ordinary brackets as applicable, then the capital gains brackets as applicable.

There are conditions and asterisks and stuff I'm leaving out of the previous paragraph, but that's enough to explain that your pension cash out will use up or fill in your standard deduction amount along with your Roth conversions, which is I think the question you were wondering about.

Collectively, the first $24.5K (or whatever) of your pension cash out and Roth conversions will be federally taxed at 0% due to the standard deduction.  Anything above that amount will start filling the 10% bracket, which since it sounds like your MFJ is about $20K wide IIRC.

But you should also consider the impact(s) of the pension cash out and Roth conversions pushing capital gains out of the 0% bracket into the 15% bracket, and any ACA subsidies being reduced, as the other posters have said.  (There can be similar effects with Social Security taxation, but that seems not to apply currently.)  Increasing AGI also often has a state tax impact.

The order of the stacking of your pension cash out and Roth conversions doesn't matter.  The 10% penalty would apply to the entire pension cash out amount because it was includable in income.  You may want to check to see if you qualify for an exception to the 10% penalty by looking at the instructions for Form 5329 Line 2.