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10% Penalty Exception at Age 55
Rev. 03/19/10; E-mail Alert 2010-5

Not all distributions from qualified plans are subject to a 10% excise tax when they are paid to a participant prior to attaining age 59½.  There are several exceptions to this rule, most notably when distributions are paid to a terminated participant who is age 55 or older.  In this article we will focus on the 10% penalty exemption for participants who attain age 55 [Code Section 72(t)(2)(A)(v)].

Payments made to a qualified plan participant — who has separated from service with their employer during or after the year they reach age 55 — will be exempt from the 10% early withdrawal penalty.

Example 1: Participant severs employment after age 55
John terminates employment March 15, 2010 and elects to receive a lump sum distribution of his 401(k) balance.  He is age 57. John’s distribution will not be subject to a 10% excise tax because he separated from service after attaining age 55.

Example 2: Participant severs 3 years before age 55, requests distribution after age 55
Henry separates from service at age 52 in 2007. On February 28, 2010, Henry becomes age 55 and calls his employer for a distribution. Henry asks if the 10% early distribution penalty will apply as he has now attained age 55. He is disappointed to learn that the penalty does apply. Why? Because the law waives the 10% penalty only for those separating from service in the year age 55 is attained or thereafter.

Example 3: Participant severs employment in year age 55 attained
Rebecca leaves employment March 19, 2010 but will not become age 55 until December 8, 2010. She withdraws her entire 401(k) balance on October 26, 2010. Will the 10% penalty apply because she had not yet attained age 55 at the time of severance nor at the time of the distribution?

No. IRS Notice 87-13 Q&A 20 (referenced below) provides guidance to clarify that distributions paid to a qualified plan participant who severed from employment during or after the year in which in which he or she reaches age 55 will be exempt from the 10% early withdrawal penalty.

Example 4: Participant severs employment after age 55 and directly rolls to IRA
Bret retires at age 56 and directly rolls his entire 401(k) balance into a traditional IRA to avoid the 20% mandatory withholding. Bret will have to wait until he reaches age 59 1/2 to withdraw from the IRA without penalty because the rule — waiving the 10% penalty after a separation of service at age 55 or after — only applies to qualified plans and not to Individual Retirement Accounts.

For more information on when the 10% excise tax will not apply, click here for our eSeminar on Hardships, In-service, Deferral Distributable Events.

 

For Reference Following is Code Section 72(t)(2)(A)

Code Section 72(t) 10-percent additional tax on early distributions from qualified retirement plans

(1) Imposition of additional tax
If any taxpayer receives any amount from a qualified retirement plan (as defined in section 4974 (c)), the taxpayer’s tax under this chapter for the taxable year in which such amount is received shall be increased by an amount equal to 10 percent of the portion of such amount which is includible in gross income.
(2) Subsection not to apply to certain distributions
Except as provided in paragraphs (3) and (4), paragraph (1) shall not apply to any of the following distributions:
  (A) In general
  Distributions which are—
    (i) made on or after the date on which the employee attains age 591/2,
    (ii) made to a beneficiary (or to the estate of the employee) on or after the death of the employee,
    (iii) attributable to the employee’s being disabled within the meaning of subsection (m)(7),
    (iv) part of a series of substantially equal periodic payments (not less frequently than annually) made for the life (or life expectancy) of the employee or the joint lives (or joint life expectancies) of such employee and his designated beneficiary,
    (v) made to an employee after separation from service after attainment of age 55,
    (vi) dividends paid with respect to stock of a corporation which are described in section 404 (k), or
    (vii) made on account of a levy under section 6331 on the qualified retirement plan.

For Reference: IRS Notice 87-13, Q&A 20 (Italic Added)

Q-20: What additional tax on early distributions from qualified retirement plans applies under section 72(t) (as added by TRA'86)?

A-20: Section 72(t) (as added by TRA'86) applies an additional tax equal to 10 percent of the portion of an “early distribution” from a qualified retirement plan (as defined in section 4974(c) of the Code) that is includible in the taxpayer's gross income. A distribution (including deemed distributions under section 72(p)) is treated as an “early distribution” unless it is described in section 72(t)(2)(A) (taking into account section 72(t)(3) & (4)). A distribution to an employee from a qualified plan will be treated as within section 72(t)(2)(A)(v) if (i) it is made after the employee has separated from service for the employer maintaining the plan and (ii) such separation from service occurred during or after the calendar year in which the employee attained age 55.
A distribution that is an “early distribution” will not be subject to the additional tax to the extent provided under section 72(t)(2)(B) (relating to deductible medical expenses under section 213), section 72(t)(2)(C) (relating to certain distributions from employee stock ownership plans), or section 72(t)(2)(D) (relating to distributions pursuant to qualified domestic relations orders). The determination of whether the additional tax under section 72(t) applies to a distribution is to be made without regard to whether the distribution is treated as a mandatory distribution for purposes of section 411(a)(11) or section 417(e).
The payor (or, if applicable, plan administrator) is not liable under section 3405 to withhold any amount on account of the additional income tax imposed under section 72(t). However, the taxpayer may have estimated tax liability with respect to such additional income tax.

 

 

To learn more, call 973-492-1880 or e-mail info@mhco.com.

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