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.
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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. The IRS separation from service exception 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.
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’s 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.
When Should Cathleen Take Her Distributions?
Let’s start by discussing the rules regarding Rule of 55 distributions. If your employer permits you to take the Rule of 55 distribution, you’ll have to do it under the terms they permit. For example,
the employer may permit withdrawals at your own discretion, while others may require the entire account be liquidated in a lump sum.
If they do, you may be withdrawing more funds than you’d like. It also has the potential to create a huge ordinary income tax liability, though it will not trigger the 10% early withdrawal penalty.
An alternative may be to take the lump sum distribution, use the funds that you need – in Cathleen’s case, to build a home – and then roll the remaining funds over into an IRA to minimize the income tax bite.
However, an employer may give you an either/or choice – either take the full distribution or do a rollover of the entire balance. If you take the full distribution, the employer will withhold 20% for income taxes, so you’ll lose that portion when you do the rollover.
What’s more, any funds rolled over from a 401(k) plan to an IRA will no longer be eligible for the Rule of 55 penalty exception.
The 72(t) Alternative
Still another option is to set up a series of substantially equal periodic payments, sometimes known as a 72(t) distribution. These are calculated based on your remaining life expectancy, which the IRS discloses in Publication 575 – Pension and Annuity Income (Page 15).x
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, times the number of months in the year of distribution.
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.
This option won’t work in Cathleen’s case because she has plans to use the money to build a house, and it will only allow her to withdraw about 3% of the plan funds.
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 completely determined by her employer.
If the option to take partial or periodic withdrawals is available, that will be the best way to minimize the tax consequences.
If her employer requires a full lump-sum distribution, Cathleen will have two real options:
1. 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
2. Take an early withdrawal on 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. Employers 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.
The Hidden Flaw in the Rule of 55
One factor for Cathleen and for anyone considering a Rule of 55 distribution to be aware of is the potential to impair your future retirement.
While you may get the benefit of access to the funds in your 401(k) for immediate need, any funds taken – whether through a lump sum or a partial withdrawal – will reduce your retirement savings.
A full lump sum distribution will have the most negative impact, virtually removing your entire 401(k) plan from providing a future source of retirement income.
The best option may be for those who have multiple 401(k) plans, with the majority of the funds held in plans from previous employers. You can then take a full liquidation on your current or last employer plan while leaving the remainder of your plans intact.
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.
The Bottom Line – Ask GFC 022 – How to Work the “Rule of 55” to Your Advantage
The “Rule of 55” can be a handy tool for penalty-free 401(k) withdrawals in certain situations, like Cathleen’s. But, there are some important things to keep in mind.
First, using this rule means you can tap into your 401(k) without that pesky 10% early withdrawal penalty, but you’ll still owe income tax. Cathleen’s case is a good example. She turned 55 and left her job in the same year, which qualifies her for this perk.
However, there are limits. You can only use this rule with your last employer’s 401(k), so if you’ve got multiple accounts, you might need to do some financial juggling.