A:

It depends.

Let's address the two penalties that will apply - the 10% early-withdrawal penalty and the 20% federal withholding - separately.

Early-withdrawal penalty
If the distribution from your Deferred Retirement Option Program (DROP) fund is made to you after you separate from service with your employer, and the separation occurred during or after the calendar year in which you reached age 55, then the amount will not be subject to the 10% early-withdrawal penalty, unless you qualify for another exception. (See list of exceptions below.)

Unless you qualify for an exception, the 10% penalty will apply if you separate from service before the year you reach age 55 and/or if the distribution occurs before you reach age 59.5.

If only a portion is rolled over to an IRA or other eligible retirement plan, only the portion that you keep (i.e. the amount not rolled over) is subject to the early-withdrawal penalty.

Federal withholding
Unless the distribution is processed as a direct rollover to an IRA or other eligible retirement plan, your employer must withhold 20% of the amount for federal tax purposes.

If only a portion is processed as a direct rollover, only the amount paid to you is subject to the 20% mandatory withholding.

If the amount is paid to you and you choose to roll over a portion to an eligible retirement plan, the portion that you keep (i.e. the amount not rolled over) is subject to income tax.

If your employer pays the distribution to you and you later decide to roll over the distribution to an eligible retirement plan, you may either:

-roll over only the amount you received (the gross distribution minus the withholding tax), OR
-roll over the gross distribution amount. To do so, you will need to make up the difference (the amount withheld for tax by your employer) out of your regular savings.

Exceptions to the 10% early-distribution penalty
The 10% early-distribution penalty will not apply if distributions made before age 59.5 are made in any of the following circumstances:

-Made to a beneficiary on or after the death of the employee.
-Made due to the employee having a qualifying disability.
-Made as part of a series of substantially equal periodic payments beginning after separation from service and made at least annually for the life or life expectancy of the employee or the joint lives or life expectancies of the employee and his or her designated beneficiary. (The payments under this exception - except in the case of death or disability - must continue for at least five years or until the employee reaches age 59.5, whichever is the longer period.)
-Made to an employee after separation from service if the separation occurred during or after the calendar year in which the employee reached age 55.
-Made to an alternate payee under a qualified domestic relations order (QDRO).
-Made to an employee for medical care up to the amount allowable as a medical expense deduction (determined without regard to whether the employee itemizes deductions).
-Timely made to reduce excess contributions under a 401k plan.
-Timely made to reduce excess employee or matching employer contributions (excess aggregate contributions).
-Timely made to reduce excess elective deferrals.
-Made because of an IRS levy on the plan.

(For related reading, see Avoiding IRS Penalties On Your IRA Assets.)

This question was answered by Denise Appleby.

RELATED FAQS
  1. Am I losing the right to collect spousal Social Security benefits before I collect ...

    The short answer is yes, if you haven't reached age 62 by December 31, 2015. The Bipartisan Budget Act of 2015 disrupted ... Read Full Answer >>
  2. How do I file taxes for income from foreign sources?

    If you are a U.S. citizen or resident alien, your income (except for amounts exempt under federal law), including that which ... Read Full Answer >>
  3. How Long Should I Keep My Tax Records?

    The Internal Revenue Service (IRS) has some hard and fast rules regarding how long taxpayers should keep their tax records. As ... Read Full Answer >>
  4. Where else can I save for retirement after I max out my Roth IRA?

    With uncertainty about the sustainability of Social Security benefits for future retirees, a lot of responsibility for saving ... Read Full Answer >>
  5. Will quitting your job hurt your 401(k)?

    Quitting a job doesn't have to impact a 401(k) balance negatively. In fact, it may actually help in the long run. When leaving ... Read Full Answer >>
  6. Can a 401(k) be taken in bankruptcy?

    The two most common types of bankruptcy available to consumers are Chapter 7 and Chapter 13. Whether you file a Chapter 7 ... Read Full Answer >>
Related Articles
  1. Retirement

    How Much Should You Have In Your 401(k) To Retire?

    Determining how much money should be in your 401(k) when you retire depends on several variables, many of which are uncertain.
  2. Investing

    How To Make Sure Your Healthcare Costs Do Not Ruin Your Retirement

    The best proactive plan of action for a stable retirement is to understand medical costs, plan ahead, invest properly, and consider supplemental insurance.
  3. Investing

    3 Small Steps to Maximize Your Investing Goals

    Instead of starting the New Year with ambitious resolutions, why not taking smaller manageable steps that can have a real impact.
  4. Taxes

    Taxes: H&R Block Vs. TurboTax Vs. Jackson Hewitt

    There are more and more tax services to help ease the pain of filing income taxes. Here's our take on three of the biggest.
  5. Investing

    7 Creative Ways to Save for an Early Retirement

    Take note of these out of the box steps you can take towards securing yourself an earlier, more comfortable retirement.
  6. Your Clients

    Tips for Making Your Nest Egg Last Longer

    If you’re trying to figure out how to make your hard-earned nest egg last, there’s one piece of advice that stands above the rest.
  7. Personal Wealth & Private Banking

    What People Hate About Financial Advisors

    Advisors need to make a living too, but doing so by cutting corners at a client's expense isn't right. Here are the top complaints against advisors.
  8. Products and Investments

    SRI Funds and Your 401(k): What You Need to Know

    Socially responsible, green and impact investing options are now DoL-approved for 401(k) plans. Here's what investors should know.
  9. Taxes

    Confused About Estimated Tax Deadlines for 2016?

    If you run a business or have investment income, pay attention to this year's estimated tax deadlines. Here are the details, and what's new for 2016.
  10. Retirement

    Retirement Plan Tax Prep Checklist

    Here's a list of items you need to have in order by tax time, including paying attention to those pesky required minimum distributions.
RELATED TERMS
  1. Sequence Risk

    The risk of receiving lower or negative returns early in a period ...
  2. Backdoor Roth IRA

    A method that taxpayers can use to place retirement savings in ...
  3. Taxes

    An involuntary fee levied on corporations or individuals that ...
  4. W-2 Form

    The W-2 form reports an employee's annual wages and the amount ...
  5. Sales Tax

    A consumption tax imposed by the government on the sale of goods ...
  6. Duty Free

    Goods that international travelers can purchase without paying ...
Trading Center