Pitfalls to Mitigate with the “Rule of 55”
Since the pandemic started, people all over the world have been re-thinking their timing strategies for retirement. The news media is calling this the “Great Resignation” or the “Great Shift”, either due to layoff or retirement. As people begin to think about leaving earlier than expected, they are beginning to worry about where their retirement income will come from.
Many companies offer their employees access to a retirement account like a 401(k). These retirement vehicles allow employees to save for retirement, often with a match from their employer on a tax deferred basis. When you begin to take distributions from these accounts, you are taxed on the distributions and could incur a penalty if certain rules are not followed. One of those penalties is early distributions. When you retire from a company that offers a 401(k) earlier than the age 55, you are penalized with a 10% early distribution penalty on any withdrawal taken. This penalty is in addition to the normal tax you would pay on the distribution. For example, let us say that Bob retires at age 53 and takes a $100,000 distribution from his 401(k), he would have to pay the normal tax on the distribution plus an additional $10,000 penalty. But, if Bob retired between 55-59 ½ and he were to take a 401(k) distribution, the 10% early distribution penalty would not be assessed if the rules are followed. This is known as the “Rule of 55”.
Here are some things that you should know about the “Rule of 55” so that you can potentially reduce the chances of paying extra money to the IRS.
- To qualify for the rule, separation of service must occur in or after the year the individual turns age 55 or older. Meaning you cannot separate from service (retire) at age 53 and wait to take distributions from the 401(k) at age 55 and avoid paying the 10% penalty. You MUST be turning age 55 or be older when you separate from service (retire) to qualify for the penalty exemption.
- The “Rule of 55”DOES NOT apply to Traditional or Roth IRAs. If you wait to retire until age 55 and then move your 401(k) funds to a Traditional IRA, the rule no longer applies, and you must follow the IRA rules set forth by the IRS. To mitigate the early distribution penalty of 10% on IRAs, you must be 59 ½. Once you move your funds to an IRA, you typically cannot move them back to the 401(k) and thus your decision is irrevocable.
- Penalty free distributions are ONLY allowed from the current employer 401(k) that the employee separates from service at age 55. For example, let us say Jim is about to retire from XYZ Corporation, but he still has an old 401(k) at ABC Company that he plans to take distributions from as well when he retires. The “Rule of 55” would ONLY apply to the funds held in the 401(k) at XYZ Corporation. The funds held at ABC Company would not qualify and would be subject to the 10% early distribution penalty because he would have retired form ABC Company before age 55. However, if Jim were to combine his funds held at ABC Company with the funds he has at XYZ Corporation BEFORE he retires, then all the funds would meet the exemption.
The “Rule of 55” can be great when utilized correctly. To avoid some of these common mistakes working with a financial professional before you retire is important. Most, if not all, of these mistakes can be avoided with a little education and guidance. Planning ahead can save you thousands in taxes. Please reach out to our office if you have any questions about the “Rule of 55”.
David S. Dixon ®
If this information has been helpful to you, please share.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Contributions to a traditional IRA may be tax deductible in the contribution year, with current income tax due at withdrawal. Withdrawals prior to age 59 ½ may result in a 10% IRS penalty tax in addition to current income tax.