A Not So Well-Known Penalty Tax Exception
By Mike Rahn, CISP
One of our clients is retiring at age 57. He was told that if he takes money from his 401(k) plan he will not be subject to the 10 percent early distribution penalty tax that applies to those younger than age 59½. Is this correct?
Yes. Over the years, Congress has expanded the number of events that qualify as exceptions to the general rule that imposes a 10 percent penalty tax on pre-age 59½ distributions from retirement plans and IRAs. The SECURE 2.0 Act of 2022 gave us the latest of those exceptions. Some exceptions, however, have been in place for several years, despite being unfamiliar to many. One of these is the exception that your client describes.
How, exactly does this penalty tax exception work?
Those who leave employment in a year in which they are—or will be—age 55 or older may take distributions from their employer’s retirement plan without being subject to the 10 percent penalty tax. For example, an individual could retire at age 54 and still qualify for the penalty tax exception as long as she will be 55 by the end of the calendar year.
Does this exception apply to all employer-sponsored retirement plans?
This exception applies to non-IRA employer plans, such as 401(k), profit sharing, money purchase, or 403(b) plans. It does not apply to SIMPLE IRAs or SEP plans.
Does this exception carry over from an eligible employer plan to an IRA if a person age 55 or older retires and rolls over his plan balance?
It does not. Once in an IRA, such balances are subject to the usual IRA rule that requires reaching age 59½ in order to be exempt from the 10 percent penalty tax. Other exceptions may apply for certain individuals, however.
Is there a potential downside to a person who avails himself of this option?
A retirement plan participant should understand that if he chooses to have a distribution that is eligible to be rolled over paid to him, the employer will withhold 20 percent of the taxable portion. This may be acceptable, since in many cases there will be a tax obligation for the distribution. But 20 percent may be a higher withholding amount than the participant desires, or than would be necessary to satisfy the tax obligation for the distribution. He would then have to wait until he files his tax return for that year in order to recoup a withholding amount that exceeded the tax obligation.
