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New 20% withholding tax affects pension distributions


CHICAGO -- Anyone with a nest egg growing securely in a company pension plan should keep an eye on the new fox patrolling the henhouse: U.S. lawmakers.

Under legislation effective Jan. 1, 1993, any lump-sum distribution from a company pension plan -- generally made to someone who retires, resigns or is fired -- will be subject to a 20 percent withholding tax if the check is paid directly to the employee. The result of what critics call a trap built into the new withholding law could be more taxes owed on April 15, 1993.

Employees who receive funds from an employer's pension plan now get a check for the full amount and have 60 days to deposit it in an individual retirement account or other qualified plan. Earnings continue to be tax-deferred. As under the new law, any funds that aren't put into the new plan are counted as taxable income.

But the new withholding requirement means employees with $50,000 stashed away in a qualified company plan will receive a check for $40,000 if the money is paid directly to them. The $10,000 balance will be held to cover potential taxes should the full distribution not be reinvested in a retirement plan.

The problem is that if the full $50,000 isn't rolled into the new plan, the $10,000 that has been withheld to pay taxes is itself treated as taxable income. Even if workers deposit the $40,000 received, they will have to pay tax on the $10,000 the IRS withheld, since it wasn't invested in the new account.

The entire $50,000 can be preserved and taxes avoided if employees are careful to keep their hands off the money. This means telling employers, before any funds are paid out, to send the $50,000 directly to another qualified pension plan or IRA, thus avoiding the 20 percent withholding requirement.

Departing employees also can ask the company to keep the money in its plan until they direct that it be moved.

Otherwise, to avoid tax liability, employees must make up, out of their pockets, the $10,000 difference that the IRS withholding creates between the old plan and the new one.

Supporters of the new law believe the measure will encourage job-changing workers to preserve more of their retirement funds in the pension system.

Critics say Congress has set a trap for workers in the midst of a stressful job change or, worse, a job loss. Many will have to unnecessarily chip away at retirement savings to pay taxes that otherwise wouldn't be due, these critics say.

The change in pension law was included in legislation passed this summer to help pay for an extension of jobless benefits. The measure is intended to raise $2.1 billion in 1993 and $26 million in 1994, said William J. Miner, an actuary with Wyatt Co. in Chicago.

He cites this sharp drop-off in anticipated government revenue as a signal that lawmakers "are well aware of the trap they have set."

"Congress is expecting that for one year the U.S. public will be either uninformed or stupid, and that the Treasury will benefit," he said.

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