By Jeremy Rodriguez, JD.
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If you have a 401(k) account or other employer sponsored retirement plan, you probably already know that a distribution before you reach age 59½ is going to be subject to a 10% penalty. One exception to the 10% early withdrawal penalty allows participants in a qualified plan to take a distribution from the plan after leaving the job as long as they are age 55 or older. This rule, sometimes called the "Rule of 55,” is an exception to the early withdrawal rules that generally levy a 10% penalty on amounts withdrawn before age 59½. This exception does not apply to IRA distributions.
To qualify for the exception, the individual must separate from service in the year they turn age 55 or older and then request a distribution. Remember, the distribution will still be subject to federal income taxes, and it may also be subject to state income taxes (depending on the state of residence). Importantly, separating from service at an earlier age, and then taking the distribution at age 55, will not qualify for the exception.
For example: In one Tax Court case, a taxpayer, whom we will call Mary, left her job when she was 53 years old. Under the terms of her company plan, Mary was eligible to take a distribution upon separation from service. The plan also allowed distributions to terminated employees, age 55 and above. Mary declined to take the distribution when she left her job but elected to begin distributions once she turned 55. Undoubtedly, Mary was under the mistaken impression that once she turned age 55, she was exempt from the 10% early withdrawal penalty. The IRS disagreed and imposed the penalty since she was not age 55 when she terminated from service. The Tax Court sided with the IRS and ruled that what matters is the age of the taxpayer when they separated from service, not when they took the distribution. As a result, the 10% penalty was upheld.
It's important to note that the Rule of 55 does not apply to IRAs. In another court case, a taxpayer, Jack, left his job at age 55 and rolled over his balance from a qualified plan to his IRA. Jack then began taking distributions from the IRA. At trial, the Court sided with the IRS and held that the subsequent distribution did not fall under the Rule of 55 and was subject to the early withdrawal penalty. Therefore, if you leave a job after turning age 55 and need all, or a portion, of your retirement funds immediately, you should be careful about rolling over funds into an IRA. Once you roll over qualified plan assets into an IRA, the Rule of 55 exception is lost. Any subsequent distributions from the IRA before age 59½ will be subject to the 10% early withdrawal penalty unless another exception applies.
Therefore, it makes sense for someone in this situation to roll over a portion of their retirement account into an IRA and take the taxable distributions directly from the retirement plan. Under this approach, they can access the monies they need without incurring an unnecessary penalty, while also continuing to defer the taxes on the remainder of the account. Of course, a taxpayer could take a Section 72(t) distribution (i.e., Series of Substantially Equal Payments), which is also exempt from the early withdrawal penalty. However, these withdrawals are subject to special rules and generally cannot be altered without triggering the penalty.
On the other hand, as long as the plan allows modifications to installments elections, withdrawals from qualified plans can be altered without triggering the 10% penalty. For example, Sally separated from service at age 56 and elected an installment distribution of $1,000 per month from the company’s qualified plan. The installment distribution qualifies under the Rule of 55 as an exception to the 10% penalty. However, after one year, Sally realizes that she actually needs $2,000 per month. If the plan allowed her to modify her installment election, Sally could change the amount and the distribution would still qualify under the Rule of 55 exception!
The ability to take out money early is a great safety net for anyone looking to retire before age 59½. However, taking funds out early decreases the long-term value of your account. This is especially true if your initial years of retirement are bad ones for the market. Therefore, it’s essential that you work with a tax advisor or financial planner to create a sustainable withdrawal strategy before accessing any retirement or IRA account.