Age-55 Exception

Dear Client:

The taxable portion of a pre-age 59½ withdrawal taken from a qualified retirement plan or traditional IRA is hit with a 10% early withdrawal penalty unless an exception applies. The list of exceptions is not identical for qualified plans and IRAs. For example, one exception for qualified plans is available if you are age 55 or older and have separated from service with respect to the sponsoring employer. This age-55 exception is not allowed for early IRA withdrawals.

Details on the Age-55 Exception

The age-55 exception is available if both of the following conditions are met:

  1. The withdrawal is made after the employee has separated from service with respect to the employer that maintains the qualified plan in question.
  2. The separation occurs during or after the calendar year in which the employee attains age 55.

Note: A retirement plan withdrawal can qualify for the age-55 exception even if the taxpayer separates from service at age 54, as long as he or she turns 55 later in the same calendar year.

Seventh Circuit Confirms No Age-55 Exception for Amounts Rolled Over into IRAs

The Seventh Circuit recently confirmed that a taxpayer who could have withdrawn funds penalty-free from his former employer’s qualified retirement plan under the age-55 exception was hit with the 10% early withdrawal penalty when he rolled over his retirement plan money into an IRA and then took an early withdrawal. The taxpayer argued that the differing lists of penalty exceptions for qualified plans and IRAs was illogical. Too bad, said the Seventh Circuit. The tax law says what it says, even though it may not necessarily be logical.

Even worse, the Seventh Circuit also concluded that the taxpayer’s failure to pay the early withdrawal penalty triggered the 20% accuracy-related penalty. Taken together, the 10% earlier withdrawal penalty and the 20% accuracy-related penalty cost the taxpayer over $24,000. The penalties could have been completely avoided with a little advance planning. Ouch!

Conclusion: Contact Us before Making Major Financial Moves

The recent Seventh Circuit case is a classic illustration of why taxpayers should contact their tax advisers before making major financial moves.

Specific to the situation explained in this letter: if you separate from service in or after the year you turn age 55 and are not yet age 59½, you should not roll over funds that you will need soon into an IRA. Instead, you should withdraw the needed funds penalty-free from the employer plan and roll over the balance into an IRA. Once funds are in the IRA, the taxable portion of any withdrawals taken from the IRA before age 59½ will be hit with the 10% early withdrawal penalty unless one of the exceptions for early IRA withdrawals applies.

Please contact us if you have any questions about the issue discussed in this letter, or questions about the tax impact of any financial transactions you may be considering.