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Did you realize that there is a provision within the Internal Revenue Code that allows you to start taking distributions from your 401(k) plan before you reach age 59½? This little-known section of the code, §72(t)(2)(A)(v), can be a real dandy if you happen to fit the requirements. The primary requirement is that you separate from service with the employer at or after age 55.
Note: although we will refer to the 401(k) throughout this article, this code provision applies to all ERISA-qualified, employer-established defined contribution plans, which includes 401(k), 403(b), 501(a), and others.
Here’s how it works: if you are working for a company and are participating in the company’s 401(k) plan, should you leave employment with that company at any time during or after the year in which you reach age 55, there will be no penalty for taking distributions from the plan. Normally, any distribution (other than specifically-qualified distributions) prior to age 59½ will result in the 10% penalty being applied, in addition to regular income tax.
It is important to note that these distributions only qualify when received from a company-established defined contribution plan – NOT an IRA account. Just to be clear:
THIS PROVISION DOES NOT APPLY TO IRA ACCOUNTS.
In order to maintain this penalty-free distribution, the funds must not be rolled over into an IRA. This is a critical distinction that you need to understand – a mistake would take away this option completely. Be certain that you completely understand how this works before starting a distribution, as it could be costly to make a mistake.
Lastly, the Pension Protection Act of 2006 made one additional change to the code: The age limit is reduced to 50 for retiring police, firefighters, and medics. Retirees from those specific jobs can take a penalty-free distribution from their accounts when they leave employment at or after age 50.
As with all defined contribution plans, normal income taxes will still apply.
Read about the potential Downside to the Age 55 Rule for 401k Plans.