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Downside to the Age 55 Rule for 401k

Downside to the Age 55 Rule for 401kIn other articles we’ve covered the Age 55 rule for 401k plans – where you’re allowed to withdraw money from your 401k penalty-free if you leave employment at or after age 55. But there’s a downside to the Age 55 rule that you need to know about. We’ll cover the downside today.

When you reach age 55 and leave employment, you may be looking to use your 401k plan as your source of income needs for a few coming years. Perhaps you plan to withdraw from the 401k until you reach age 59½, when you’ll have access to other deferred money, or maybe until you reach age 62 and start receiving Social Security.

But there could be a problem in your strategy. Your 401k administrator might only allow a one-time lump-sum withdrawal from the plan! Many plans have this restriction – the reasoning being that they see the plan primarily as an accumulation vehicle, and they do not want to be in the position of maintaining long-term distributions.

So, for example, Steve retires from his job at age 56, knowing that he can take withdrawals from his 401k plan without penalty. So when he maps this out, he needs approximately $50,000 from his 401k plan each year. He needs this amount until he reaches age 62, when he’ll start taking his Social Security and drawing his pension.

When Steve contacts the 401k administrator to set this up, he learns that the plan only allows a lump sum distribution! This means that Steve would have to take a distribution of $150,000 to get him to age 59½. Of course this would result in significantly more tax than Steve anticipated, but there’s not much else he could do, other than going back to work. (It should be noted that not all 401k plans have this restriction – many will allow multiple withdrawals, but many do restrict withdrawals to a one-time lump sum. Check with your plan administrator as you devise your strategy.)

If he rolls over the 401k plan to an IRA, the Age 55 rule no longer applies. However, Steve has another option that can help the overall tax situation, by staging his withdrawals.

Staging Withdrawals

If Steve took the entire lump sum of $150,000 from his 401k in one year (rolling over the rest of the account to an IRA), the tax would be approximately $32,070, since he’s single. If he was married, the tax would be approximately $23,778. But, since he only needs $50,000 in the first year, he could withdraw that $50,000 for a tax cost of approximately $5,940 ($3,448 if he was married). The remaining 401k would be rolled over into an IRA.

Then in the subsequent years, Steve could take “early” withdrawals of $50,000 each year, paying the 10% penalty. His total tax each of the two following years (his age 57 and 58) would work out to $10,940 per year (or $8,448 if he was married). So his total tax for the three years amounts to $27,820 – a savings of $4,250. If he was married the total tax would have been $20,344, saving $3,434 by staging. However, any way you look at it, this is costing an extra $10,000 in penalties, so it’s not the boon you thought it would be (if your plan is restricted like this).

Often, the best option to deal with this downside to the Age 55 rule is to come up with some other source of income during the intervening years. A part-time job could be the answer, helping Steve through the couple of years before he reaches age 59½. Or perhaps one of the other exceptions to early withdrawal could apply for a portion of his income needs. At age 59½ he could have the entire amount rolled over into an IRA and he’d have unfettered (unpenalized) access to the money in any amount.

26 Comments

  1. Cassy Johnson says:

    I will be 59.5 on 122618. I was laid off indefinitely in 2010@ 51yrs old -will I avoid the IRS 10% penalty if I withdraw from my 401k with my old employer ?

    Also, the 59..5 rule-is it 180 days after you’ve turned 59.5 that there’s no penalty?

    1. jblankenship says:

      If you are 59 1/2 years old, you will not be penalized on a withdrawal from a 401k account.

      59 1/2 is six months (not 180 days) after your 59th birthday. So, if born on June 26, 1959, you would be 59 1/2 years old on December 26, 2018.

  2. Bethany M Roberts says:

    My previous employer shut down operations in 2016 when I was 53 years old. While I move a substantial amount of my investment to an IRA, I left close to $60k in that 401k. I will be turning 55 this year and wish to ‘retire’. Does the 55 Rule apply to me in relation to my previous employment’s 401k? I would like to start receiving distributions.

    1. jblankenship says:

      No, since your former employment ended at your age 53, this is prior to age 55, so the age 55 rule will not apply to this account. Your option at this point would mostly be the 72(t) Series of Substantially-Equal Periodic Payments (SOSEPP) in order to avoid the penalty.

  3. beavatron says:

    Scenario: The company has declared the 401k plan closed to further contributions, and employees must decide whether and where to roll their balances to. The company is also closing in a few weeks. Since I am over 55, can I take a distribution as I rollover the majority of the 401k balance, without penalty? The technicality of the timing for when the separation of service (in IRS parlance) occurs vs. the rollover is unclear to me. Any advice on where to get an answer would be appreciated.

    1. jblankenship says:

      If you’re leaving the company/the plan is closing, since you’re over age 55 any distribution will be penalty-free. You’ll owe tax on the distribution, but no penalty. Just make sure you take the distribution from the 401k, not after you’ve rolled over to an IRA. If you rollover money to the IRA first, you are not allowed to take any money from the IRA penalty-free until you reach 59 1/2.

      1. beavatron says:

        Thanks for your reply. I definitely will take the distribution from the 401k. Happy to have confirmation that separation of service can take place after I do the distribution & rollover.

        1. jblankenship says:

          I did not confirm that you can separate from service after the distribution and rollover. In order to do the distribution without penalty, you must have separated from service first. Apologies if that was not clear in my reply.

          1. v538 says:

            If the plan is terminated but I am still working there for 4 more months, can I avoid the penalty based on the 55 yr old rule?

          2. jblankenship says:

            Only once you’ve left employment at the company – from the way I understand the rule.

  4. Ray says:

    My company dose participate in the rule 55 401k plan my question is what would be the maximum amount I could withdraw a year

    would it be the same maximum amount you could take out as a loan of 50k

    I really only need around 40K until 59.1/2

    1. jblankenship says:

      The maximum is going to be something your plan administrator can tell you about. There is no legal maximum in the Internal Revenue Code.

      1. Matthew M Hylland says:

        Are you sure about this?
        From the IRS website: “The maximum amount that the plan can permit as a loan is (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”
        here: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-loans

        1. jblankenship says:

          Positive.

          The information you’re referring to is about a 401k loan. I’m referring to a withdrawal of funds from the 401k, which is allowed without penalty if you leave the employer at or after age 55. Otherwise (if you left the employer before age 55) you have access without penalty when you’re at least 59 1/2 years old.

          1. Matt Hylland says:

            Oops, yep sorry for the confusion. Thanks!

          2. jblankenship says:

            No problem – glad to clarify when it’s not clear at first.

  5. […] 2. Age 55 Exception – Begin after age 55, having left employment after age 55 (also read about the potential Downside to the Age 55 Rule for 401k Plans) […]

  6. Theresa says:

    My situation is I took a loan in 2015 but before I could pay it back I went on permanent disability (stage 4 Mets Breast Cancer to bone). Loan just sat with no further payments and I didn’t need to draw on it with disability and social security. Now it’s 2018 and I received a call that the company I worked for when I was employed has merged with another company and they are closing the 401k plan and going elsewhere. Now I need to move my plan into an IRA but my loan needs to be claimed on taxes – it’s $30k. My questions Can I get the loan income without penalty? Can I get an extra 2k for cushion and can the rest be rolled into IRA without penalty and tax? I’m on limited income and they wouldn’t let me divide between 2 years for taxes and I have to do all this within the next few months. I took loan at age 53, left just short of 55 and now I’m 56.

    1. jblankenship says:

      Unfortunately you’ll likely have a penalty on the distribution, since you were under age 55 when you left the company. It’s possible you might get the age 55 exception if you left during the calendar year you were going to reach age 55, so you should contact the company administering the 401k plan to determine how they will code the distribution. The same would go for any additional distribution that you might want (beyond the loan) that is not to be rolled over into an IRA.

      1. Steve Dupree says:

        Does that mean that you could take a loan at age 54 or earlier, get terminated in the year you turn 55, let the loan lapse, and get it counted as a Rule of 55 penalty free withdrawal?

        1. jblankenship says:

          I think so. Of course, don’t take my word as gospel on this. I suggest asking a tax attorney about it, or the IRS, to be certain.

  7. Sharon says:

    One topic that I have not seen addressed in any articles on the Age 55 rule — can you quit/cease working for your current employer that holds your 401k, and then be re-hired by the same company while taking equal distributions under this rule?

    1. jblankenship says:

      I doubt it, unless you are re-hired under a classification that is not allowed access to the 401k plan. Even then, it’s apparent that you are gaming the system with this set of actions – I would not advise it.

  8. JoeTaxpayer says:

    Just add this to the list of awful things about the tax code. We we retired, my wife was over 55, and this helped us bridge the gap to her turning 59-1/2.
    How awful it would have been when we were let go (and timing was perfect, that fired turned into retired) had we not been able to do this. Fortunately, this is behind us.

  9. Paul M Stifel says:

    It seems like the ‘substantially equal payments’ option might also work. Not knowing the balances in the deferred accounts, I can’t tell whether the RMD table amounts would be enough; and they have to go on for 5 years, so he’d have to deal with the Social Security overlap–perhaps by delaying SS and getting more later. If the RMD table amount was not enough, (and there were no non-deferred savings to draw on) I’d consider borrowing against my house to make up the difference, repaying either from the excess once SS started or via a IRA withdrawal once he reached 59.5. Any of these options would seem to be cheaper than paying big penalties or big taxes for lump sum options.

    1. jblankenship says:

      The amount in the account is exactly the problem, Paul. You bring up a great point, that the SOSEPP could help, but it’s unlikely that the balance would support the size of payment he’s looking for.

      Thanks for reaching out – it’s a great point to include…

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