Qualified plan distributions paid to participants who are younger than age 59 1/2 are generally subject to a 10% excise tax. There are several exceptions to the age-59 1/2 rule, however, most notably the exception for distributions paid to terminated participants age 55 or older.
Under Code Section 72(t)(2)(A)(v), payments made to qualified plan participants who have separated from service with their employer during or after the year they reach age 55 are exempt from the 10% early withdrawal penalty. Here are some practical examples:
Example 1: Participant severs employment after age 55
John terminates employment on March 15, 2016, and elects to receive a lump-sum distribution of his 401(k) balance. He is age 57. John’s distribution will not be subject to a 10% excise tax because he separated from service after attaining age 55.
Example 2: Participant severs employment before age 55; requests distribution after age 55
Henry separates from service in 2013 at age 52. He reaches age 55 on February 28, 2016, and calls his employer to request a distribution. Henry asks if the 10% early distribution penalty applies now that he is 55 years old and is disappointed to learn that it does. Why? Because the 10% penalty is waived only for those participants who separate from service in the year they attain age 55 or thereafter. The fact that Henry did not receive the actual distribution until after age 55 is irrelevant. (He must wait until after age 59 1/2 to avoid the penalty.)
Example 3: Participant severs employment at age 55
Rebecca leaves her job on March 19, 2016, but will not be 55 years old until December 8, 2016. She withdraws her entire 401(k) balance on October 26, 2016. She had not yet attained age 55 at the time of severance nor at the time of the distribution. Will the 10% penalty apply?
No. The IRS clarified (Notice 87-13 Q&A 20) that distributions paid to a qualified plan participant who severs service during or after the year in which he/she reaches age 55 are exempt from the 10% early withdrawal penalty.
Example 4: Participant severs employment after age 55 and directly rolls over account to an individual retirement account (IRA)
Bret retires at age 56 and directly rolls over his entire 401(k) balance into a traditional IRA to avoid the 20% mandatory federal income-tax withholding. Bret will have to wait until he reaches age 59 1/2 to withdraw funds from the IRA without penalty because the rule waiving the 10% penalty after separation of service at age 55 or after applies only to qualified plans and not to IRAs.
If you have any questions regarding the exceptions to the early withdrawal penalty rules, please contact a Lumin Financial advisor today.
Disclosure: Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific investment, or investment strategy. Investments involve risk and are not guaranteed. Information has been gathered from sources believed to be reliable, but cannot be represented as accurate or complete. Before investing, you should consult your investment, tax, or legal advisor.