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Most people are aware that if you take money out of a tax-deferred retirement account before you turn 59 1/2, you will owe income tax on the amount taken out plus a 10% early withdrawal penalty.
Many people are also aware that the early withdrawal penalty has several exceptions. In fact, there are several of them, which is where things may get a little confusing. Which one do you choose, and how much and when do you take it?
Cathleen R. of Massachusetts posed the following question, which covers a wide range of possibilities:
"In May of 2016, I will be leaving my company, and in July of 2016, I will turn 55." I intend to make money out of my 401(k) to build a house. I'm familiar with IRS Rule 55, and I understand that I'll have to report the withdrawal as income but won't have to pay the 10% penalty.
Do I have to make a withdrawal from my 401K in 2016, the year I separate from the military and the year I turn 55? Can I take a penalty-free withdrawal if I wait until 2017? Because I will have earned income from January through May of 2016, my goal is to minimize my taxable income to the greatest extent practicable.
I'd also like to know if I may make several penalty-free withdrawals, basically taking a 401K withdrawal in 2017 and 2018 to reduce my taxable income. (Please note that I have no imminent plans to roll my 401K into an IRA, as I am aware that IRAs are not Rule of 55 qualifying plans.)."
Cathleen's question covers three areas: the Rule of 55's general application, when it should be used, and how to spread out dividends to limit the actual income tax liability to a bare minimum.
Getting Penalty-Free 401(k) Withdrawals Using the Rule of 55
Cathleen can withdraw from her 401(k) plan, which will be taxed as ordinary income but will be exempt from the 10% early withdrawal penalty. This is made possible by the IRS's separation from service exception. This Rule, known as the Rule of 55, allows employees to withdraw money from their 401(k) or 403(b) plans without incurring a penalty.
The employee must be released from employment during or after the year in which he or she turns 55, though certain government employees may be released as early as age 50. Cathleen qualified since she turned 55 the same year she was let off from her job, in 2016. The term "separated" can relate to being fired, laid off, or terminated in some other way.
This isn't relevant in Cathleen's case, but it's an important thing to remember in this conversation. You will not be entitled to take advantage of the Rule of 55 if you still have money in a retirement plan from an employer from which you were separated before the year in which you turn 55. Deferring distributions until you reach age 59 1/2, when withdrawals are no longer restricted, will be your only option for avoiding the early withdrawal penalty.
However, I'd like to make a few key distinctions in response to Cathleen's inquiry. Cathleen mentions the need to withdraw monies in order to construct a home. Because an early withdrawal from a 401(k) for the purpose of purchasing a home does not qualify for the penalty exemption, this might add a layer of complexity to the subject.
Only withdrawals from an IRA qualify for the exemption, and only up to $10,000 for first-time homebuyers. So let's be clear: we're not blaming the exemption on her desire to construct a new home.
Second, the Rule of 55 exemption does not apply to IRA funds, as Cathleen concedes in her query. Because it only applies to 401(k) plans, Cathleen's Rule of 55 exemption will be lost if she converts her 401(k) to an IRA.
Another thing to keep in mind, even if it doesn't apply to Cathleen's circumstances, is that the Rule of 55 only applies to your previous employer's 401(k) plan. If you start taking funds before turning 59 1/2 and have plans from previous jobs, the Rule of 55 will not apply to you.
If you had 401(k) plans from past companies, you should roll them over into your current 401(k) plan if you are allowed to do so.
There's one more constraint, and it's a big one. So far, we've been talking about IRS regulations that govern the Rule of 55. However, whether or not you can take advantage of the Rule will be determined by the terms of your employer's 401(k) plan. You will not be able to accept distributions if they ban withdrawals before a specific age, such as 59 1/2 or 62. Even though the IRS allows hardship withdrawals, no rules force the employer to participate.
Cathleen's Distributions: When Should She Get Them?
Let's begin by going over the rules for Rule of 55 distribution. If your employer allows you to take the Rule of 55 distribution, you must follow their guidelines. For example, your company may allow you to make withdrawals at your leisure, while others may require you to liquidate the entire account in one go. If they do, you may find yourself withdrawing more money than you intended. It also has the potential to result in a substantial ordinary income tax bill; however, the 10% early withdrawal penalty will not be triggered.
Another option is to receive the lump sum distribution, use the cash you need – in Cathleen's instance, to buy a house – and then roll the remaining funds into an IRA to reduce your tax bill. On the other hand, an employer may offer you the option of taking the entire distribution or rolling over the entire amount. If you take the entire distribution, the company will deduct 20% for income taxes, so you'll lose that amount when you roll it over.
Furthermore, any monies transferred from a 401(k) plan to an IRA will no longer qualify for the Rule of 55 penalty exemption.
The 72(t) Substitute
Another method is to set up a 72(t) distribution, which is a sequence of essentially equal periodic payments. The IRS publishes your remaining life expectancy in Publication 575 - Pension and Annuity Income, which is used to compute these (Page 15).
According to this chart, Cathleen will have to compute 360-month recurring payments at the age of 55. She may figure out how much her yearly payout will be by dividing her 401(k) balance by 360 months, multiplied by the number of months in the distribution year.
For example, if Cathleen has $360,000 in her 401(k), she is allowed to take out $12,000 every year without incurring an early withdrawal penalty.
Once the payouts begin, they must last for five years or until you reach the age of 5912, whichever comes first.
Cathleen won't be able to take this option since she wants to use the money to build a house, and it only allows her to withdraw roughly 3% of the plan's funds.
Spreading Out Distributions to Save Money on Taxes
The last half of Cathleen's inquiry is this. While there may be some leeway here, the reality is that her employer will have ultimate control over the distributions from her plan. If you have the option of taking partial or periodic withdrawals, it will be the greatest strategy to reduce your tax liability.
Cathleen will have two options if her company requests a complete lump sum distribution:
Defer having a new house built until she is 59 1/2 years old when she will be able to take any amount of money from her 401(k) without penalty, or
Take an early withdrawal from her 401(k) for as much money as she needs to build the house, and be prepared to pay a 10% early withdrawal penalty as well as ordinary income tax on the amount removed.
A 401(k) loan, however, is not an option. Former employees are not permitted to take out loans from their employers because repayment is no longer guaranteed. Furthermore, the amount of money that can be borrowed is limited to 50% of the plan balance, with a maximum loan amount of $50,000.
That might not be enough to get the new house built in the first place.
The Rule of 55's Hidden Flaw
Cathleen, and anyone considering a Rule of 55 distribution, should be aware of the risk of jeopardizing their future retirement. While you may benefit from instant access to funds in your 401(k), any monies are taken – whether in a single amount or as part of a partial withdrawal – will affect your retirement savings.
A full lump sum payout will have the most negative impact, thereby eliminating your whole 401(k) plan as a source of future retirement income.
Those with several 401(k) plans, the majority of which are held in past employers' plans, may find that this is the best alternative. You can then liquidate your current or previous employer's plan in its entirety while keeping the rest of your plans intact.
Cathleen, I'm sorry there isn't a better option; the regulations are what they are. I recommend that you speak with the trustee of your 401(k) plan as well as your tax preparer about your specific situation. I'm sure the amount of tax you'll have to pay on any distributions and any penalties for taking them early will influence your decision.