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News from, April 20, 2011
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Exception to the Rule: Early Distribution Under Age 59 ½...With No Penalty?
By Laura L. Zink

In our profession, we often see more exceptions to the rules than the rules themselves. Many times, when we delve into Internal Revenue Code and Department of Labor regulations, interpretation of that material can lead us down many paths — some of which we may not have anticipated. So was the case, when, what should otherwise have been a simple distributable event for a terminated participant of a 401(k) plan prompted a phone call to my desk.

The participant’s investment advisor called on behalf of the participant inquiring how his client, Age 55, may take a distribution from the plan subject to the IRS 10% early withdrawal penalty on those funds without rolling those funds over. We are often conditioned to instinctually reply, "To avoid the IRS 10% early withdrawal penalty, a participant must be Age 59½ or older…” However, the investment advisor wished to extol as much detail related to this participant and the situation, so he and I talked it out. He laid out all the details before me. I soon learned the participant was Age 55, he had been terminated in that year, and the investment advisor seemed sure he had heard of some rule in which this person would not be subject to the early penalty.

Typically, distributions received before a participant reaches Age 59 ½ are considered to be taken early or prior to typical retirement age. This is meant to encourage participants to retain qualified retirement assets for their retirement years. By using the Age 59 ½ threshold as my sole determining factor of whether the distribution would be considered early, I felt sure my instinctual assumption was correct; this Age 55 participant would be taking what code would indicate to be an early withdrawal. As such, he would be subject to an early distribution penalty of 10% additional tax. The financial advisor continued to relay the pertinent details, and the language regarding the IRS 10% early withdrawal penalty began to roll. He was under Age 59½ and all details presented to me indicated this was pretty straight-forward. I delved right into a careful synopsis of typical IRS 10% early withdrawal penalty language. Because the investment advisor’s objective seemed focused on exceptions to this rule, I was sure to mention all the accepted, general exceptions to the rule I could recall:

  • If the distribution is made due to separation of service and is "part of a series of substantially equal periodic payments (made at least annually) for your life (or life expectancy) or the joint lives (or joint life expectancies) of you and your designated beneficiary” as described in Publication 575;

  • If you are totally and permanently disabled;

  • If the distribution is received by a beneficiary after the death of a plan participant;

  • If the distribution is part of a Qualified Domestic Relations Order (QDRO);

  • Being used for deductible medical expenses exceeding 7.5% of adjusted gross income;

  • From a plan with written provisions specifically providing a schedule for your entire interest if, as of March 1, 1986, you had separated from service and began receiving payments under that plan provision;

  • From an employee stock ownership plan (ESOP) for dividends on employer securities in the plan;

  • Because of an IRS levy of the plan; or

  • A qualified reservist distribution.

Afterward, I expected the financial advisor to totally agree with me that this participant did not meet the criteria and was not eligible to waive the 10% penalty. Surprisingly, he patiently replied, "What about the Age 55 Rule? That’s what it’s called, I think.”

You might be thinking what I was at that moment, "What Age 55 Rule…?” I put the call on hold and quickly conferred with a colleague who had attained his Certified Financial Planner (CFP) designation, who remembered that the "Age 55 Rule” had been the topic of a question on his study materials. He looked up the question and so began my exceptional learning moment!

There is another exception. The Internal Revenue Code also provides another exception for the 10% early withdrawal penalty and is found in IRC 72(t)(2)(A)(v). Interpretation of this code indicates that in the year in which an employee separates (termination or early retirement) from service is age 55 or older, the 10% penalty will not apply and that employee can receive the distribution penalty free. This is certainly an exception to the early withdrawal rule! I needed a moment to absorb this in the practical and logistical administration of a plan - a terminated participant who is Age 55 or older could fall within criteria in which they do not have to meet the Age 59 ½ benchmark to avoid the 10% early withdrawal penalty.

The participant’s situation certainly met this exception. He was Age 55 in the year in which he separated from service. The distribution paperwork was processed within the scope of his preferences and, the distribution was appropriately coded to reflect this exception. We were sure to advise the investment company releasing the participant’s funds to show the proper distribution code in Box 7 of the subsequent Form 1099-R that would later be generated for this distribution.

This learning moment provided more than enough reason to spend additional quality time with the Code. It provided reinforcement that we should not become complacent in our daily assumptions, nor should we translate such assumptions by operating on auto-pilot. In this case, the details of the participant’s situation mattered. Assumptions can easily lead us down the wrong path if we operate with blinders on. The situation also helped develop an even greater appreciation of associated professionals – other cooks in this 401(k) plan’s kitchen – to cooperatively learn from during the ebb and flow of plan administration. Moving forward, I’ll not assume I know the entire recipe in that proverbial kitchen and allow that (sometimes) having more than one cook is a good thing.

About the Author: Laura L. Zink is a senior retirement plan coordinator with Benefits Administrators, LLC in Lexington, KY, and has enjoyed her current position for the past two years. Prior to third-party pension plan administration, she acquired 15 years of experience as a licensed insurance and securities professional. Zink is an alumnus of Marshall University, University of Kentucky and Eastern Kentucky University. She has enjoyed 17 years of marriage to her wonderful husband, Loren, and they share two beautiful daughters, Brandi (Age 14) and Peyton (Age 8).

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