A reader writes in, asking:
“I recently heard that if I am laid off at age 55, I can get money out of my 401K before turning 59.5 without having to pay the 10% penalty. Is that true, and if so could you elaborate on how that works?”
This rule comes from Internal Revenue Code 72(t)(2)(A)(v), which states that the 10% additional tax for early distributions does not apply to any distributions that are “made to an employee after separation from service after attainment of age 55.”
In reality, however, the rule is slightly more lenient than that. IRS Notice 87-13* states that “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.”
In other words, you can take money out of a qualified plan account (such as a 401(k)) without having to pay the 10% penalty, if:
- You have left the employer in question, and
- You left that employer in or after the calendar year in which you reached age 55.
A Few Points of Clarification
There are several points about this rule that often trip people up, so let’s go through them one by one.
First, it doesn’t matter how/why the separation from service occurred. Quitting counts. Getting laid off counts. Getting fired counts.
Second, it is the separation from service (not just the distribution) that must occur at the age in question. For example, if you left your employer at age 53, even if you are now age 55, distributions from your 401(k) with that employer would still be subject to the 10% penalty, unless you meet one of the other exceptions.
Third, you don’t have to be retired to qualify for this exception to the 10% penalty. For example, if at age 56 you leave Employer A and take a job with Employer B, your 401(k) account from Employer A is now accessible penalty-free — even though you’re not retired.
Fourth, it doesn’t have to be your most recent employer. For example, if, at age 56, you leave Employer A and take a job with Employer B, then you retire from Employer B at age 58, your 401(k) accounts from both Employer A and Employer B are now accessible penalty-free (because in each case, you separated from service in or after the calendar year in which you reached age 55).
Fifth, this exception does not apply to IRAs, and that’s true even if the money in the IRA came from a 401(k) that would have met the requirements. For example, if you leave your employer at age 57 and roll your 401(k) into an IRA account, distributions from that IRA would still be subject to the 10% penalty, unless you meet one of the other exceptions. (And yes, in some cases, this is an excellent reason to wait to roll over a 401(k) until you have reached age 59.5.)
*Unfortunately, the only place I can find this notice online (it is from 1987, after all) is in the Internal Revenue Cumulative Bulletin 1987 [Part 1], available here. (Be prepared to wait a while for the download. The relevant wording is on page 441.)