Helping clients who are separated from service after age 55
By Michael J. Buckner
GamePlan Financial Marketing, LLC
The Internal Revenue Code that provides an exception from the premature distribution penalty that can be a helpful provision for your clients if they meet the requirements.
Given today’s volatile economy, many individuals have found themselves downsized from their jobs and recipients of early retirement packages. Many have left a current employer for better opportunities. Individuals who find themselves in this position — who separate from service during or after the year in which they attain age 55 and who need to access money in plans of the employer from which the separation from service occurred — can do so without being subject to the 10 percent federal tax penalty for premature distributions.
The Internal Revenue Code that provides the exception from the premature distribution penalty is §72(t)(2)(A)(v). This exception can be a helpful provision for your clients if they meet the requirements.
Here’s how it works: If your client has worked for a company and participated in that company’s 401(k) plan and then leaves employment with that company at any time during or after the year in which he or she reaches age 55, the 10 percent federal penalty tax will not apply on the amount of any distribution your client withdrawals from the plan. However, there will generally be ordinary income taxes dues on the distribution amount. Normally, any distribution from an employer-sponsored plan prior to age 59½ would result in a 10 percent federal tax penalty applied to the taxable amount of the distribution, unless an exception applies.
It is important to note that this separation of service exception to the federal tax penalty on premature distributions only applies to distributions that are made from an employer-sponsored qualified plan. This applies to employer plans from which your client separated from service during or after the calendar year of reaching age 55 and does not apply to an individual retirement arrangement (IRA).
If funds from a qualified plan are rolled over to an IRA, the age 55 penalty exception is lost. Unless a different exception applies, distributions from the IRA will be subject to the 10 percent federal tax penalty until the IRA owner reaches age 59½. This is a critical distinction that your clients need to understand — a mistake would take away this penalty tax exception completely. Make certain that your clients completely understand how this works before taking a distribution, as it could be costly to make a mistake. Let’s take a look at a couple of examples:
1. Frank participated in a 401(k) plan until 2009, when he retired at age 55. In 2011, at age 57, Frank received a single-sum distribution of his plan benefits. Because Frank separated from service from the employer that sponsored the plan during or after the calendar year in which he attained age 55, his distribution amount will not be subject to the 10 percent federal tax penalty, but he will still owe ordinary income tax on the amount he received.
2. Karen was downsized from her employer at age 56. She was a participant in her employer’s 401(k) plan. Karen is aware of the “age 55 and separated from service rule”; however, she does not want to leave her funds in her employer’s 401(k) plan, as the investments have performed poorly.
Karen has received numerous job offers from other employers, but would like to take a year off to travel. Karen decides to take some funds directly from her employer sponsored 401(k) plan to cover her expenses for one year. She will not owe the 10 percent federal penalty tax, but she will owe any ordinary income tax on the taxable portion of the distribution. She then affects a direct rollover of the remaining portion of her funds into an IRA1 as she has no plans to access them until retirement when she will be over age 59½.
Note: although we refer to the 401(k) throughout this article, the Internal Revenue Code provision that provides the exception for distributions made after separation from service during or after the calendar year in which the employee attains age 55 applies to all tax-qualified, employer-sponsored plans, which includes 401(k), 403(b) and defined benefit plans.
1 Any transaction that involves a recommendation to liquidate a securities product, including those within an IRA, 401(k) or other retirement plan for the purchase of an annuity or for other similar purposes can be conducted only by individuals currently affiliated with a properly registered broker/dealer or registered investment adviser. If you are unsure whether or not the information you are providing to a client represents general guidance or a specific recommendation to liquidate a security, please contact the individual state securities department in the state(s) in which you conduct business.
This information is designed to provide general information on the subjects covered. Pursuant to IRS Circular 230, it is not, however, intended to provide specific legal or tax advice and cannot be used to avoid tax penalties or to promote, market or recommend any tax plan or arrangement. Please note that GamePlan Financial Marketing, LLC, its affiliated companies, and their representatives do not give legal or tax advice. Encourage your clients to consult their tax advisor or attorney.
For Financial Professional use Only – Not for Use with the General Public.