Penalty Free Distributions at Age 54

Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in New Jersey is representative of a common question on the 10% Early Distribution Penalty Tax.

"My client, who is age 54, has a 403(b) plan and wants to stop working and care for her husband who has cancer for the third time. Can she roll from her 403(b) plan where she works now into a former 401(k) plan she has and then take distributions without paying a 10 percent early distribution tax?"

Highlights of the discussion on penalty exceptions for early distributions

Ideally, retirement assets should be reserved for retirement. But sometimes life’s circumstances necessitate early access. While there are several options for relief from the 10 percent early distribution penalty tax, rolling from a 403(b) to a 401(k) plan will not help because distributions from either plan have the same early distribution penalty tax exceptions.

Generally, amounts an individual withdraws from a retirement plan or IRA before reaching age 59½ are called “early” or “premature” distributions. Beyond including the pretax portion of an early distribution in taxable income for the year taken, the recipient must pay an additional 10 percent early withdrawal penalty tax, unless an exception applies under Internal Revenue Code Section (IRC §) 72(t)(1). Keep in mind, that even Roth assets must be held for at least five years plus be distributed because of reaching age 59½, death, or disability to be qualified and have the earnings exempt from the 10 percent early distribution tax.

Here are some options to consider in the couple’s situation for avoiding the 10 percent early distribution tax when taking retirement plan or IRA distributions before age 59½.

Separation from service distributions – Available from qualified retirement plans

If your client turns age 55 soon in 2024, or if her husband has been working and participating in a retirement plan and left employment in or after the year he turned age 55, there is a penalty exception that could apply. Simply stated, if a person takes a distribution after both reaching age 55 and separating from service, a penalty exception applies under IRC §72(t)(2)(A)(v). (Age 55 is replaced with age 50 for public safety employees of a state, or political subdivision of a state, in a governmental defined benefit or defined contribution plan.)

Substantially Equal Periodic Payments – Available from qualified retirement plans or IRAs

The wife or husband could consider taking “72(t)” periodic payments for the longer of a) five years or b) until reaching age 59½ from their respective accounts as allowed under IRC §72(t)(2)(A)(iv). These payments must continue until the recipient meets both five years and age 59½ unless modified due to death or disability. Generally, there cannot be changes in the distributions during this payment period. So, if they need more money, they should consider taking distributions from a different retirement plan or IRA of theirs and that distribution may be subject to the 10 percent penalty tax unless another exception is met. Revenue Ruling 2002-62 outlines the 72(t) periodic payment requirements.

Disability – Available from qualified retirement plans and IRA

In this case, if the husband is disabled, he may be able to take distributions from his retirement account(s) or IRA without the 10 percent penalty. The IRS defines disability for this purpose in IRC §72(m)(7), and the definition is quite strict:

“… an individual shall be considered to be disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration. An individual shall not be considered to be disabled unless he furnishes proof of the existence thereof …”

Some disabled individuals file IRS Schedule R, Credit for the Elderly or Disabled, with their IRS Forms 1040. The schedule requires a physician’s certification that a person meets the definition of disabled. Alternatively, a physician’s signed statement attesting to an individual’s permanent and total disability can serve as proof of the condition. Check the administrator’s policy.

Terminally ill individual distributions (TIID)– Available from qualified plans (except governmental 457(b) plans) and IRAs

Section 326 of the SECURE Act created IRC §72(t)(2)(L) which allows an employee who is a terminally ill individual to receive a distribution on or after the date on which the employee has been certified by a physician as having a terminal illness. IRS Notice 2024-2 provides guidance on TIIDs from retirement plans without incurring an early distribution tax. The definition is

“… a terminally ill individual means an individual who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 84 months or less after the date of the certification.”

Plans that allow TIIDs will report the distribution on Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. If the plan doesn’t offer TIIDs, the employee can still claim TIID treatment by filing Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. There is no limit on the amount that can be distributed by the terminally ill individual.

Conclusion

By knowing the exceptions to the early distribution tax for retirement plans and IRAs, advisors can better help their clients take distributions without the penalty tax applying. For more information on these and other exceptions to the tax on early distributions refer to this IRS Chart.