Thousands of men and women, age 55 and older, are still employed because they don’t know that they can access their 401(k) or 403(b) without penalty. The IRS code contains a little-known penalty exception called the “separation from service” exception. CPA’s and financial advisors call it the Rule of 55.
The gist is that if separated from service in the year in which you turn 55, you may withdrawal funds from your 401(k) or 403(b) plan without penalty. If you feel that this exception is an opportunity for you, you should know that Federal and State income tax will still apply. The “Separation From Service” benefit affects the 10% penalty only.
While you may have already known about this rare exception, there are a few things that you might have not known.
(1.) The Exception Only Applies To Your Current 401(k) or 403(b)
The exception we’re discussing here does not apply to retirement plans left dangling at former employers. It only applies to the current 401(k)’s and 403(b)’s, where you still work
Example: Ann worked at The Building Depot for 10 years and built a $50,000 401(k) balance. She left for Lower’s Building Center at the age of 51, for an increase in pay, and did not move her 401(k) that she had accumulated from the Building Depot. After years of adding to her 401(k) at Lower’s, she decided to retire at the age of 57. The 401(k) that still remained at The Building Depot is for the Rule of 55 exception. If, however, she were to transfer the $50,000 in the 401(k) from The Building Depot into the Lower’s 401(k) plan, and then retire, the $50,000 from The Building Depot and the Lower’s 401(k) would be eligible for the exception.
(2.) The Exception Does Not Apply To IRA’s
Another factoid surrounding the “Rule of 55” is that the this exception does not apply to IRA’s. IRA’s have their own list of exceptions, and generally, the exception list is longer for IRA’s than 401(k)’s or 403(b)’s. But in this area, retirement plans are more generous.
The IRA does have a 72(t) plan that is available for early access. But several landmines exist, and penalties as well. In fact, while we’re discussing early withdrawals, please check with your CPA before making any decision. You will certainly be glad that you did.
The type of separation of service doesn’t matter to the IRS. Whether you were fired with or without cause, terminated because of downsizing, or you simply quit, you still will be deemed eligible or ineligible, based on the qualifications listed above.
(3.) If You Leave Your Job Before The Age Of 55, It Doesn’t Count
Very important point here. Once again, the age in question here is 55 years old. But it is very important to note that the age is pertinent to the date of separation of service, not the date of distribution. A notorious Tax Court Case held that the age of separation of service must be in the year that you turn 55 years old, no exceptions. Distributions may occur in any year thereafter. Obviously if you’re 59½, then you will meet an entirely different exception and the 10% penalty wouldn’t apply anyway.
We can’t emphasize the importance of meeting with skilled advisors and CPA’s thru this process. It may save you thousands.