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A recent call with a financial advisor in Maryland is representative of a common question on exceptions to the 10% additional tax on early retirement plan withdrawals.
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.
“I have a client who is age 57 and wants to take some withdrawals from their 401(k) plan they have with a former employer. What are the rules for a separated participant taking penalty-free withdrawals from their former employer’s plan?”
Internal Revenue Code (IRC) §72(t)(2)(A)(v) provides an exception to the 10% additional tax on early withdrawals for 401(k) plan distributions “made to an employee after separation from service after attainment of age 55.” This exception to the additional tax is sometimes referred to as the “Rule of 55.” The exception does not require substantially equal periodic payments; each otherwise qualifying distribution after the applicable separation can qualify.
There is a similar rule that applies to qualified public safety employees and certain private-sector firefighters. For qualified public safety employees receiving distributions from a governmental plan, and for private-sector firefighters receiving distributions from certain employer retirement plans, the age-55 threshold is replaced by the earlier of age 50 or 25 years of service under the plan. Qualified public safety employees include certain police, firefighters, emergency medical service employees, corrections officers, forensic security employees, and specified federal public safety employees.
The Rule of 55 exception applies to distributions from qualified retirement plans such as 401(k) and 403(b) plans but is not available for distributions from IRAs or IRA-based employer plans (such as savings incentive match plans for employees (SIMPLE) IRA and simplified employee pension (SEP) plans.
To qualify for this exception, a plan distribution must meet two general requirements:
The distribution is made after the participant separates from service with the employer maintaining the plan; and
The participant’s separation from service occurs during or after the calendar year in which they attained age 55.
(Notice 87-13, 1987-1 C.B. 432, Q&A-20)
If your client, currently age 57, requests a distribution now, whether the distribution qualifies for the penalty exception will depend on the age your client attained during the year they separated from service. If your client separated from the plan sponsor in the year they turned age 55 (or after), then the exception would apply.
Note that a participant who separates from service with the plan sponsor before the calendar year in which they turned 55 will not be eligible for the exception. In Watson v. Commissioner, T.C. Summary Op. 2011-113 (Sept. 28, 2011), the U.S. Tax Court ruled that a participant who received a plan distribution at age 55, but separated from service with the plan sponsor at age 53, could not claim the exception.
The Rule of 55 may allow former plan participants to take penalty-free distributions earlier than usual. Preserving it is a consideration when contemplating a change of employer.