Marilyn, age 55, has been downsized. She wants to know: Can she take money out of her 401(k) when she leaves her job? And can she take money out of her IRA?
Marilyn's 401(k) plan allows her to take her money out when she leaves her company. As a result, she will be able to take a distribution from her plan.
Will she be subject to the Internal Revenue Service 10 percent penalty for early withdrawal because she is under the age of 59 1/2?
No. A special rule applies to 401(k) plans.
The early-withdrawal penalty on 401(k) plans does not apply after attaining the age of 55. You don't have to wait to age 59 1/2 to avoid the penalty.
For example, if Marilyn withdraws $10,000 from her 401(k) after severance, the $10,000 will be taxable as income, but will not be subject to the early-withdrawal penalty.
If Marilyn were a "qualified public safety employee," she would avoid the penalty as early as age 50. You are a "qualified public safety employee if you provided police protection, firefighting services, or emergency medical services for a state or municipality, and you separated from service in or after the year you attained age 50," quoting from IRS Publication 575, "Pension and Annuity Income."
You can find the publication online at www.irs.gov. Search for "Separation from service" in the publication. Also refer to "Topic 558 — Additional Tax on Early Distribution from Retirement Plans, Other Than IRAs" at http://tinyurl.com/7rmh566.
A different set of rules applies to IRAs — Marilyn has to be age 59 1/2 to avoid the early-withdrawal penalty. Because she is only 55, a $10,000 withdrawal will trigger a $1,000 penalty, plus her $10,000 will be subject to income taxes.
It may be possible to avoid the IRA early-withdrawal penalty under an exception that requires a commitment to a series of substantially equal periodic payments under Section 72(t) of the Internal Revenue Code.
To qualify, Marilyn would have to continue substantially equal periodic distributions without interruption for at least five years or until age 59 1/2, whichever is later.
If Marilyn were to pursue this route, I would recommend involving her accountant from the start. The actual dollar amount that Marilyn takes out of her IRA through the years needs to be calculated correctly for the exception to apply. The IRS provides a number of different methods by which the calculation must be made. Once you choose the method of calculation and start the distributions, you have to keep applying the same method.
Usually, your IRA custodian will provide you with a form to fill out when you are ready to take a distribution. The distribution form will ask you to identify the type of distribution you are requesting and whether or not it qualifies for an exception from the IRS penalty. The IRA custodian will usually provide a pamphlet that describes the IRS requirements for qualifying for the exception.
Another good source of information on the exception from the early-withdrawal penalty is the actual tax form that some taxpayers have to file after taking a distribution.
That's IRS Form 5329. Even if you don't have to file Form 5329, it helps to read the instructions to see the various exclusions to the penalty.
Another resource is an IRS chart, "Retirement Topics — Exceptions to Tax on Early Distributions," that shows a list of exceptions to the 10 percent penalty at http://tinyurl.com/cgdnzfe.
There also is IRS Publication 590, "Individual Retirement Arrangements." You may obtain this booklet from the IRS for free by calling 1-800-TAX-FORM.
Of the 145.4 million individual tax returns filed in 2011, 5.7 million returns reported a penalty for withdrawing money from retirement plans, for a total of $5.7 billion, according to Statistics of Income Bulletin.
A final word of caution: Talk to your accountant before taking withdrawals, especially if you want to take advantage of 72(t). This is not a good way to test your do-it-yourself skills.
Julie Jason welcomes your questions/ comments (readers@juliejason.com).