By Sarah Brenner
The ongoing Covid pandemic has upended the workforce. Many individuals are reconsidering their careers. Some workers may be heading towards early retirement, either due to layoff or personal choice.
With early retirement comes questions about retirement accounts. Can these accounts be accessed? If so, will there be penalties? One important step that advisers can take to address client questions is to explain “the rule of 55.” This rule is often misunderstood, leading to potentially significant and unexpected penalties.
Of course, retirement accounts are meant to be used for retirement. To discourage workers from tapping these accounts prematurely, there are penalties for early withdrawals.
A 10% early distribution penalty will generally apply to any taxable distribution taken from a retirement account before age 59 ½. Clients should be warned that the penalty applies in addition to any taxes owed on the distribution. This can be a sizable tax hit. For example, a client who takes a $100,000 early distribution from her retirement account could be looking at an additional $10,000 in penalties on top of the taxes due on the distribution.
But Congress has a heart. It recognized that life happens and sometimes people need to access their retirement accounts at younger ages. The tax code includes a laundry list of exceptions to the 10% early distribution penalty. These exceptions provide a way out for those who can meet the qualifying requirements. However, this is no easy road. The Tax Court has thrown the book at taxpayers from all walks of life, including teachers, accountants, and lawyers, who ran afoul of these complicated rules.
The exception to the 10% penalty applicable to retirement plan distributions when an individual separates from service in the year he reaches age 55 or later may be attractive to clients who are considering early retirement. The good news is that if an individual is eligible for this exception under the law, the plan cannot limit it. But advisers should be careful to understand exactly how “the rule of 55” works and to avoid frequent pitfalls.
A common area of confusion is the timing of the age 55 exception. Early retirement cannot be “too early” if a client hopes to use this exception to access retirement savings without penalty. The separation from service must be in the year the individual turns age 55 or older. (For certain federal, state, and local public safety workers, the age for the exception is 50.) Retiring at an earlier age will not work. If you have a client who retired at age 45, this exception will not be available.
Keep in mind it is the age in the year of separation from service that matters. Age at the time of the distribution is not relevant when it comes to this exception. For example, if a client separated from service at age 49 and is now age 57 and looking to take a distribution this year, the age 55 exception is not available. This is because even though the client may be over age 55 at the time of the distribution, her age at the time of separation from service was under age 55, and that does not qualify for the exception.
Another pitfall to avoid is the misunderstanding of which retirement accounts have the rule of 55 available. This exception is only available to plans like a 401(k). It is never available to IRAs, and that includes SEP and SIMPLE plans.
While there is a long list of exceptions to the 10% early distribution penalty, not all the exceptions are available to all retirement accounts. While some are available to both IRAs and plans, some are available only to plans and others are available only to IRAs. The rule of 55 is one of those exceptions that is available only to plans and not IRAs.
Clients looking to take advantage of the age 55 exception may be surprised to learn that this exception may not allow access without penalty to all of their retirement accounts. If a client has an IRA and a 401(k) and they separate from service at age 55 from the company with the 401(k), she will have access to the 401(k) funds penalty-free but not the IRA. (This assumes no other exception applies to the IRA dollars.)
Furthermore, the exception is only available to the plan where the employee separates from service at age 55 or later. This can also come as a surprise to clients. Many have more than one retirement account. It is not uncommon for clients to have multiple plans from different employers over the years. These clients will be restricted in which funds they can access penalty-free. For example, a client who still has funds in an old retirement plan from a previous employer (where he separated from service prior to age 55) will not be able to access those funds without penalty even if he separates from service with a subsequent employer at age 55 or later.
Another trap for the unwary is rolling over a plan distribution to an IRA and then looking to take a penalty-free distribution using “the rule of 55”. This cannot be done. The age 55 exception never applies to IRAs. This is true even if the IRA is funded by a rollover from a plan where the exception would have been available. Advisers will want to be careful here because a rollover is irrevocable, so there is no way to undo it. Letting the rollover stand and then attempting to roll the funds back to the plan also is highly unlikely to be successful. It is unlikely that a plan would welcome back a former employee and allow IRA funds to be rolled back into the plan.
The age 55 rule can be a great tool to allow those clients retiring early to access their retirement account without hefty penalties. Advisers should know how this exception to the 10% penalty works and which clients it will work for and which it will not. This can be a critical opportunity to help your clients navigate the challenging move from their working years to their retirement years.
About the author: Sarah Brenner, JD, is director of retirement education for Ed Slott and Co. She has worked for almost 20 years helping clients solve complex technical IRA questions. She is a contributing writer and editor for Ed Slott’s IRA Advisor newsletter, distributed to thousands of financial advisers nationwide, and writes for several areas of the company’s website, IRAHelp.com. Get more information on Ed Slott and Company’s Virtual 2-Day IRA Workshop, Instant IRA Success. Plus, see Slott’s updated and No. 1 new release, The New Retirement Savings Time Bomb.