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The Age 55 Rule for 401(k) Accounts

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:

  1. You have left the employer in question, and
  2. 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.)

Investing Blog Roundup: Finding the Optimal Portfolio

A pattern I’ve seen over and over is that, when an investor starts to learn about passive investing, they get stuck trying to figure out how to allocate their portfolio. They can’t figure out exactly how much they want in Fund A as opposed to Fund B, and they can’t quite decide whether or not they should include Fund C.

As Rick Ferri explains this week, trying to find the precisely optimal portfolio is an exercise in futility — even for the experts with access to the best data and software — because the critical inputs (including average returns for asset classes and correlation between them) change meaningfully over time.

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How Social Security Disability Benefits Are Calculated

A reader writes in, asking:

“I have a medical condition that would automatically qualify me for Social Security disability benefits. What I am trying to figure out is whether I should file for those benefits now or wait a few years until I’m 62 and file for retirement benefits. Could you explain for readers how disability benefits are calculated?”

The easiest way to get an estimate of your potential disability benefit is to create an account on the SSA.gov website. If you sign in and click over to the “estimated benefits” tab, you can see what your disability benefit would be if you were deemed disabled right now. (You can also see what your retirement benefit would be, given certain assumptions.)

If you’re interested in understanding the actual math though, the short answer is that disability benefits are calculated very similarly to retirement benefits, but with fewer years of earnings history in the calculations.

More specifically:

  • Your disability benefit is calculated as if it were a retirement benefit, and as if you were age 62 at the beginning of your 5-month disability waiting period.*
  • The “primary insurance amount” upon which the disability benefit is based is calculated in exactly the same way that it would be for a retirement benefit. That is, it still replaces a percentage of your “average indexed monthly earnings” [AIME], with a lower percentage being replaced the higher your AIME is.

The primary difference between retirement benefit calculations and disability benefit calculations is that your AIME is calculated differently.

How AIME is Calculated for Disability Benefits

In non-disability cases, your AIME is calculated based on your 35 highest years of (wage-inflation-adjusted) earnings.

With disability benefits, however, the law recognizes that you may not have been able to acquire 35 years of earnings. So an additional calculation must be done to determine how many years will be included in the calculation.

Specifically, the SSA counts the number of years beginning with the year in which you reach age 22 and ending with the year before the year you become disabled. Then they subtract the lesser of:

  • One fifth of that total number of years (rounded down), or
  • 5 years.

Note that this “beginning with age 22″ business is only with regard to determining how many years they will count, not which years they will count. In other words, if some of your highest-earning years are actually before age 22, those years can be included in the calculation.

Example 1: If you become disabled in the year in which you turn 36, there would be 14 total years between age 22 and the year before the year you become disabled. From that, they subtract the lesser of:

  • One fifth of 14 years, rounded down (i.e., 2 years), or
  • 5 years.

So the calculation of your disability benefit would be based on your 12 highest years of (wage-inflation-adjusted) earnings.

Example 2: If you become disabled in the year in which you turn 59, there would be 37 total years between age 22 and the year before the year you become disabled. From that, they subtract the lesser of:

  • One fifth of 37 years, rounded down (i.e., 7 years), or
  • 5 years.

So the calculation of your disability benefit would be based on your 32 highest years of (wage-inflation-adjusted) earnings.

*In order to apply for disability benefits, you must have been disabled for 5 full consecutive months. This “waiting period” begins with the first month in which you were disabled, but no earlier than the 17th month before the month you apply, no matter how long you were disabled before then.

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Investing Blog Roundup: Loading Up on Muni Bonds?

Municipal bonds can be a useful tool for investors with taxable brokerage accounts, given that their interest is exempt from federal income tax (and in some cases state income tax). This week, however, author/advisor Allan Roth points out a few reasons why investors might want to place a limit on the portion of their portfolio that they allocate to muni bonds.

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Should I Really Be Buying Stocks (or Bonds) Now?

A reader writes in, asking:

“Lately I’ve seen expert after expert saying that a big stock market correction is coming because of Greece and a bond correction is coming because of rising interest rates. My question is whether it still makes sense to be investing money. If stocks and bonds are going to be less expensive in the near future, shouldn’t I just wait?”

Personally, I place no value in expert opinions about where the market is going.

For example, with regard to bonds, people have been predicting the bursting of a “bond bubble” for almost five years now. In August of 2010, Jeremy Siegel and Jeremy Schwartz wrote the following in an article for The Wall Street Journal:

“Ten years ago we experienced the biggest bubble in U.S. stock market history. [...] A similar bubble is expanding today that may have far more serious consequences for investors. It is in bonds, particularly U.S. Treasury bonds. Investors, disenchanted with the stock market, have been pouring money into bond funds, and Treasury bonds have been among their favorites.”

Near the end of the article they concluded that, “those who are now crowding into bonds and bond funds are courting disaster.”

And yet, over the last five years, Vanguard’s Intermediate-Term Treasury Fund has earned an annualized return of just over 3%. That’s not exactly off the charts, but it’s hardly a “disaster.” And it’s definitely not the sort of thing I think of when I imagine a financial bubble bursting. (In other words, it’s exactly the sort of ho-hum return one would typically expect from Treasury bonds.)

By keeping your money in cash in order to avoid a “bond bubble,” you miss out on interest that you could have earned in the meantime. And the longer you end up waiting for the correction, the more interest you forgo.

And with regard to stocks, high profile experts are similarly unreliable. For example, think back to December of 1996. As of that point in time, the stock market (as measured by the S&P 500) had quadrupled in value over the last 10 years. And, on December 5, 1996, Fed Chairman Alan Greenspan (i.e., the person then regarded as both knowing more about the economy and having more power over the economy than anybody else) gave a speech in which he publicly suggested that stock prices might be “unduly escalated” due to “irrational exuberance.”

That’s as clear of a get-out-of-the-market signal as anybody can hope for. And yet, if you took your money out of the market immediately after hearing that speech, you missed the 112% (!) increase in value that occurred from December 1996 to March 2000.

In short, knowing that a market decline is coming isn’t especially useful unless you know when it is coming — and even the experts get that wrong on a regular basis.

Investing Blog Roundup: What to Make of CAPE (aka PE10)

Cyclically-adjusted price-earnings ratio (CAPE) — aka PE10 — is often touted as a way to predict stock market returns. This week, researcher Wade Pfau takes a look at the usefulness and limitations of CAPE, including what conclusions we should draw from current CAPE levels.

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