Options for Avoiding Early Distribution Penalty

By Beverly DeVeny, IRA Technical Expert

Follow Me on Twitter: @BevIRAEdSlott

A client is leaving his employer. He is over age 55, but not yet age 59 ½, and he will need money from his retirement plan for living expenses. What are his options?

Employees who separate from service in the year they turn age 55 or later can take distributions from their employer plan with no early distribution penalty. This is an exception to the early distribution penalty rules.

Some employer plans will not allow you to take periodic, or ongoing, distributions from the plan. Instead, they require you to take your entire balance all at once. The funds can then be rolled over to your IRA. But distributions from an IRA prior to age 59 ½ will be subject to the 10% early distribution penalty (there are certain exceptions to the penalty).

One option is to set up a series of substantially equal payments (also called 72(t), SEPP, or SOSEPP payments) from the IRA. You can take penalty-free distributions from your IRA as long as you follow the strict set of rules that accompany this exception to the early distribution penalty.

72(t) payments must continue for at least 5 years or until you reach age 59 ½, whichever is later. The 5 years runs until you are 5 years past the date of the first distribution. If the first distribution is made in July 2013, then the schedule is not finished until July 2018, even though you take your fifth annual payment in July 2017 (payment one in 2013, two in 2014, three in 2015, four in 2016, and five in 2017). This trips up a lot of people.

If you do mess up the payment schedule, the 10% early distribution penalty will be owed on all distributions taken prior to age 59 ½. For someone who starts a schedule at age 52, all distributions will now be subject to the penalty. For someone who starts a schedule at age 57, the penalty is capped at all distributions taken for the first 2 ½ years – those prior to age 59 ½.

If you are thinking about setting up this type of payment plan to avoid the 10% early distribution penalty, be sure you work with an advisor who has experience in these types of transactions. There are all sorts of pitfalls not mentioned here that can put you at risk of owing the penalty. You can find a list of Ed Slott trained advisors on our website, www.irahelp.com.