Most people are aware that if you withdraw funds from a tax-sheltered retirement plan before you reach age 59 1/2 you will have to pay income tax on the amount of the distribution plus a 10% early withdrawal penalty.
Many are also at least vaguely aware that there are exceptions to the early withdrawal penalty. And in fact, there are actually several of them, and that's where it can get confusing. Which one do you take, and how much and when?
Cathleen R. of Massachusetts wrote in with a question that covers the range of possibilities:
“I will be separating from my company in May of 2016, and turning 55 in July of 2016. I plan to withdraw funds from my 401K to build a house. I am familiar with the IRS Rule of 55, and know that I will have to claim the withdrawal as income, but I will not have to pay the 10% penalty.
My question is, do I have to take the withdrawal from my 401K in 2016, the year in which I separate service and the year I turn 55? Or can I wait until 2017 and still take a penalty free withdrawal? My goal is to minimize my taxable income as I will have earned income Jan-May of 2016.
I would also like to know if I can take multiple penalty free withdrawals, essentially taking a withdrawal from my 401K in 2017 and 2018 in order to minimize my taxable income? (Note, I have no immediate plans to roll my 401K into an IRA, as I know IRA's are not qualified plans to the Rule of 55.)”
Cathleen's question addresses three topics: the general application of the Rule of 55, when it will need to be taken, and how to best keep the actual income tax liability to an absolute minimum by spreading out the distributions.
Using the Rule of 55 to Get Penalty-free 401(k) Withdrawals
Cathleen can indeed make withdrawals from her 401(k) plan, subject to ordinary income tax, but exempt from the 10% early withdrawal penalty. IRS provision 72(t) makes this possible. This provision, sometimes referred to as the Rule of 55, enables employees to take distributions from their 401(k) or 403(b) plans without having to pay the penalty.
The employee must be separated from service during or after the year he or she reaches age 55 although it can be as early as age 50 for certain government workers. In Cathleen's case, she qualifies because she turned 55 in the same year that she was separated from her employer, 2016. “Separated” can refer to laid off, quit, or otherwise terminated.
This doesn't apply in Cathleen's situation, but it's a point worth emphasizing in this discussion. If you still have money in the retirement plan of an employer that you were separated from before the year in which you turn 55, you will not be eligible to take advantage of the Rule of 55. Your only option to avoid the early withdrawal penalty at that point will be to defer taking distributions until you turn age 59 1/2, when withdrawals will no longer be restricted.
Based on Cathleen's question however I want to make some important distinctions. Cathleen references needing to withdraw the funds in order to have a house built. This can put a confusing wrinkle into the question, because making an early withdrawal from a 401(k) to purchase a home does not qualify for the penalty exemption.
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That exemption applies only to withdrawals from an IRA, and only up to a maximum of $10,000 for a first-time homebuyer. So let's make clear the distinction that we are not attributing the exemption to the fact that she wants to build a new home.
Second, as Cathleen acknowledges in her question, the Rule of 55 exemption does not apply to IRA accounts. It's strictly for 401(k) plans, so if Cathleen rolls over her 401(k) into an IRA, the Rule of 55 exemption will be lost.
Something else to be aware of, even if it doesn't apply in Cathleen situation, is that the Rule of 55 applies only to the 401(k) plan of your last employer. If you have plans from previous employers, the rule of 55 will not benefit you if you begin withdrawing funds before turning 59 1/2.
Good advice here is that if you have 401(k) plans from previous employers, you should roll them over into your current 401(k), if you are permitted to do so.
One other limitation, and this one is pretty important. So far we've been discussing the Rule of 55 based on IRS regulations. But whether or not you can actually take advantage of the rule will depend upon stipulations in your employer's 401(k) plan. If they prohibit withdrawals before a certain age, say 59 1/2 or 62, you will not be able to take distributions at all. Though the IRS permits hardship withdrawals, there are no regulations requiring that the employer participates.
When Should Cathleen Take her Distributions?
Let's start by discussing the rules regarding Rule of 55 distributions. If you use the rule, you must do so by taking a series of substantially equal periodic payments. These are calculated based on your remaining life expectancy, which the IRS discloses in Publication 575 – Pension and Annuity Income (Page 15).
According to this chart, Cathleen, at age 55, will have to calculate periodic payments based on 360 months. She can determine the amount of the annual distribution by dividing the amount of her 401(k) by 360 months, divided by 30.
So for example, if Cathleen has $360,000 in her 401(k) plan, she is entitled to withdraw $12,000 per year which will not be subject to the early withdrawal penalty.
Once the distributions begin, they must continue for a period of five years or until you reach age 59½ – whichever is longest.
Cathleen did not say how much money is in her 401(k) plan, nor the amount that she will need in order to build a new house. But I think it's safe to assume that since the annual amount she can withdraw from plan without incurring the early withdrawal penalty will be relatively small – less than 3% of the balance of the plan – accumulating enough funds for the new house may be a slow process.
There's another complication as well. The amount that you can withdraw from the plan penalty free is limited by the number of months in the year. So if she were to take a distribution in December of 2016, it will be limited to 1/12 of the annual amount. So if the annual amount was $12,000, which she could withdraw in 2017 and beyond, she will be limited to just $1,000 in 2016.
Spreading Out the Distributions to Minimize Income Taxes
This is the last part of Cathleen’s question. But while there might be some wiggle room here, the reality is that the distributions from her plan will be limited by life expectancy requirements. If she has $90,000 in the plan, she will only be able to draw $3,000 penalty-free in 2017 and subsequent years. For 2016, it will be no more than a few hundred dollars.
Given that limitation, Cathleen will have two real options:
- Delay having a new house built until she turns 59 1/2, and can withdraw any amount of money from her 401(k) penalty free, or
- Take as much money out of the 401(k) as she needs to have the house built, and be prepared to pay the 10% early withdrawal penalty as well as the ordinary income tax on the amount withdrawn.
Unfortunately, a 401(k) loan is not a solution either. Employer's do not permit loans to former employees, since repayment can no longer be guaranteed. In addition, loans are limited to no more than 50% of the plan balance, up to a maximum of $50,000. That might not be enough to have the new house built anyway.
Cathleen, I'm sorry that there isn’t a more satisfactory answer, but those are the rules. I would suggest that you discuss your situation in some detail with both the 401(k) plan trustee and your tax preparer. I'm sure that the amount of tax you will have to pay on any distributions – plus any early withdrawal penalties – will have an impact on which way you will decide to go.