Navigating Rule 55: Understanding Separation Procedures for Target Employees (2024)

The separation of service rule 55 is often overlooked in the qualified retirement planning. Most people are familiar with the age 59½ rule that allows an individual to begin receiving distributions from a retirement plan OR an IRA account without any 10 percent early withdrawal penalty.

The separation of service rule states that if an employee, who is participating in a company retirement plan such as a 401(k) plan, leaves the employer during the year in which they turn age 55 or older, distributions from the retirement plan are not subject to the additional 10 percent tax penalty.

TheSeparation from Service exceptioncan benefit workers who have a Target-sponsored retirement account such as a 401(k) and are looking to retire early or need access to the funds if they’ve lost their job near the end of their career. It can be a lifeline for Target workers who need cash flow and don’t have other good alternatives.

Here’s how theSeparation from Service exceptionworks and whether you should consider using it.

What is the Separation from Service exception (55 Rule) ?

TheSeparation from Service exception sometimes called “Rule of 55” or “55 Rule”is an IRS provision that allows workers who leave their job for any reason to start taking penalty-free distributions from their current employer’s retirement plan once they’ve reached age 55. It gives Target employees, who are looking to retire earlier than normal or those who need the cash flow, a way to take distributions from their retirement plans sooner than is typically allowed.

Taking a distribution from a tax-qualified retirement plan, such as a 401(k), prior to age 59 ½ is generally subject to a 10 percent early withdrawal tax penalty. However, the IRS Separation from Service exception may allow you to receive a distribution after reaching age 55 (and before age 59 ½) without triggering the early penalty if your Target-sponsored plan provides for such distributions.

However, any distribution would still be subject to an income tax withholding rate of 20 percent. If it turns out that 20 percent is more than you owe based on your total taxable income , you’ll get a refund after filing your yearly tax return.

For example: In one Tax Court case, a taxpayer, whom we will call Nancy, left her job when she was 53 years old. Under the terms of her company plan, Nancy was eligible to take a distribution upon separation from service. The plan also allowed distributions to terminated employees, age 55 and above. Nancy declined to take the distribution when she left her job but elected to begin distributions once she turned 55. Undoubtedly, Nancy was under the mistaken impression that once she turned age 55, she was exempt from the 10% early withdrawal penalty. The IRS disagreed and imposed the penalty since she was not age 55 when she terminated from service. The Tax Court sided with the IRS and ruled that what matters is the age of the taxpayer when they separated from service, not when they took the distribution. As a result, the 10% penalty was upheld.

One very important difference between the separation of service exception and the age 59½ rule is that the separation of service exception only applies to qualified retirement plans and not IRA accounts.

In another court case , a taxpayer, Robert, left his job at age 55 and rolled over his balance from a qualified plan to his IRA. Robert then began taking distributions from the IRA. At trial, the Court sided with the IRS and held that the subsequent distribution did not fall under the Separation from service exception and was subject to the early withdrawal penalty. Therefore, if you leave a job after turning age 55 and need all, or a portion, of your retirement funds immediately, you should be careful about rolling over funds into an IRA. Once you roll over qualified plan assets into an IRA, the Rule of 55 exception is lost. Any subsequent distributions from the IRA before age 59½ will be subject to the 10% early withdrawal penalty unless another exception applies.

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How to use the rule of 55 to retire early

Many companies have retirement plans that allow employees to take advantage of theSeparation from Service exception, but Target may not offer the option.

401(k) and 403(b) plans are not required to provide forSeparation from Service exceptionwithdrawals, so don’t be surprised if your Target-sponsored plan does not allow for this exception. Many companies see the rule as an incentive for employees to resign in order to get a penalty-free distribution, with the unintended consequence of prematurely depleting their retirement savings.

Here are the conditions that must be met and other things to consider before taking aSeparation from Service exceptionwithdrawal.

• Retirement plan offers them. Target’s plan offers a 401(k) or 403(a) or (b) that allowsSeparation from Service exceptionwithdrawals. Some plans prohibit withdrawals prior to age 59 ½ or even 62.
• Age 55 or older. You leave your position (voluntarily or involuntarily) at Target in or after the year you turn 55 years old.
• Money must remain in the plan. You fully understand that your funds must be kept in Target’s plan before withdrawing them and you can only withdraw from Target’s plan. If you roll them over to an IRA, you lose the rule of 55 tax protection.
• Potential lost gains. You understand that taking early withdrawals means forfeiting any gains that you might otherwise have earned on your investments.
• Reduce taxes. You can wait until the start of the next calendar year to begin rule of 55 withdrawals when your taxable income should be lower if you are not working.
• Public safety worker. If you are a qualified public safety worker (police officer, firefighter, EMT, correctional officer or air traffic controller), you might be able to start five years early. Make sure you have a qualified plan that allows withdrawals in or after the year you turn 50 years old.

However, as with any financial decision, be sure to check with a trusted advisor or tax professional first to avoid any unforeseen consequences.

Should you use the Separation from Service exception ?

Determining whether or not to take early withdrawals under theSeparation from Service exceptionwill depend on your unique financial situation. You’ll want to have a clear understanding of your plan’s rules, how much you’d need to withdraw, and what your annual expenses will likely be during your early retirement years after leaving Target. Figuring out those issues should help you know if taking an early withdrawal is the right decision for you.

Here are some situations where it’s likely that taking early withdrawals would not be the right move.

• If it would push you to a higher tax bracket. The amount of your income for the year in which you begin the withdrawal plus the early withdrawal might put you into a higher marginal tax bracket.
• If you’re required to take a lump sum. Target's plan might require a one-time lump sum withdrawal, which may force you to take more money than you want and subject you to ordinary income tax liability. These funds will no longer be available as a source of tax-advantaged retirement income.
• If you’re younger than 55 years old. You might want to leave Target before you turn 55 and start taking withdrawals at age 55. Note this is NOT allowed and you will be assessed the 10 percent early withdrawal penalty.

Other important considerations

If you’re thinking of taking aSeparation from Service exceptionwithdrawal, you’ll also want to consider a few other things:

• If you have funds in multiple former employer plans, the rule applies only to the plan of your current/most recent employer. If you have funds in multiple plans that you want to access using theSeparation from Service exception, be sure to roll over those funds into your Target’s plan (if it accepts rollovers) BEFORE you leave the company.
• Funds from IRA plans that you might want to access early can also be rolled into your current plan (while still employed) and accessed that way.
• If you so choose, you can continue to make withdrawals from your former employer’s plan even if you get another job before turning age 59 ½.
• Be sure to time your withdrawals carefully to create a strategy that makes sense for your financial situation. Withdrawing from a taxable retirement account during a low-income year could save you in taxes, particularly if you believe your tax rate may be higher in the future.
• Bear in mind that the only real advantage of theSeparation from Service exceptionis avoiding the 10 percent penalty. Meanwhile, the tax deferral is sacrificed, which may turn out to be more valuable if other financial resources that are not tax-qualified can cover expenses for the coming years, allowing you to save the 401(k)/403(b) distribution until later years.

Other Exceptions

You may be able to access the funds in your retirement plan with Target without a tax penalty in a few other ways, depending on your circ*mstances.

There is an exception called the 72(t) option which allows withdrawals from your 401(k) or IRA at any age without any penalty. This option is called SEPP (Substantially Equal Periodic Payments), and these payments are not subject to the 10 percent early withdrawal penalty. Once these distributions begin, they must continue for a period of five years or until you reach age 59 ½, whichever comes later.72(t) payments have suddenly become a better deal for IRA owners and company plan participants.

Also known as “substantially equal periodic payments,” 72(t) payments are advantageous because they are exempt from the 10% early distribution penalty that usually applies to withdrawals before age 59 ½. You can take them from an IRA at any time, but only from a workplace plan after leaving Target.

There are several downsides to 72(t) payments.

• First, they must remain in place for at least 5 years or until age 59 ½, whichever comes later. This means a 45-year old IRA owner must maintain her payments for almost 15 years.
• Second, if the payments are modified before the end of the 5-year/age 59 ½ duration, you are subject to a 10% penalty (plus interest) on all payments made before 59 ½. Modification will normally occur if you change the payment schedule (e.g., stop payments), change the balance of the account from which payments are being made (e.g., a rollover to the account), or change the method used to calculate the payment schedule (except for a one-time switch to the RMD method – see below).

There are three(3) acceptable ways to calculate 72(t) payments:

• The required minimum distribution (RMD) method. Payments are calculated like lifetime RMDs. Therefore, they fluctuate each year. The RMD method normally produces the smallest payout among the three methods. Once you use the RMD method, you can’t switch out of it.
• The fixed amortization method. Payments are calculated like fixed mortgage payments. After using this method for at least one year, you can switch to the RMD method without penalty.
• The fixed annuitization method. Payments are calculated by dividing the account balance by an annuity factor. Like the amortization method, they remain fixed, and you can switch to the RMD method after the first year.

However, on January 18, the IRS released Notice 2022-6, which said that 72(t) payment schedules started in 2022 or later can use an interest rate as high as 5%. (And, if 120% of the Federal mid-term rate rises above 5%, you can use a rate as high as the 120% rate.) This is great news because the higher the interest rate, the higher the payments will be. This change allows you to squeeze higher payments out of the same IRA balance. (Note that you can’t change interest rates for a series of 72(t) payments already in place.)

Other circ*mstances that exempt you from the early withdrawal penalty include:

• Total and permanent disability
• Distributions made due to qualified disasters
• Certain distributions to qualified reservists on active duty
• Medical expenses exceeding 10 percent of adjusted gross income
• Withdrawals made to satisfy IRS obligations

But the IRS offers other exceptions to the early withdrawal penalty.

Bottom line

If you can wait until you turn 59 ½, withdrawals after that age are not typically subject to the 10 percent IRS tax penalty. However, if you are in a financially safe position to retire early, theSeparation from Service exceptionmay be an appropriate course of action for you.

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

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