Take-Away:  Accessing a retirement account funds without a penalty, other than an IRA, is possible at age 55 years, but only if there has been a separation from service. However, this rule is often misunderstood.

Background: One of the exceptions to the 10% penalty for early withdrawals from a retirement plan account is the rule of 55. This rule applies when the plan participant separates from service in the year that he/she attains age 55 years or later. The rule is often relied upon by plan participants who are considering an early retirement. This exception is conferred by law; the qualified plan cannot limit or prohibit this right. However, to qualify for this exception from the penalty, the separation from service must occur in or after the year the individual turns age 55 or older. An earlier age, 50 years, is available for the exception for law enforcement officers, firefighters, emergency medical service workers, air traffic controllers, and other federal law enforcement employees.

Only Qualified Plans: This age 55 separation from service exception from the 10% penalty is only available to qualified plan participants, e.g. 401(k) participants. It is not available for traditional IRAs or for SEP and SIMPLE plans.

Timing: What is important is the timing of the participant’s retirement. The participant’s early retirement cannot be ‘too early’ if the participant hopes to use this exception to access retirement savings without any penalty. For example, the Tax Court held that a teacher was liable for the 10% penalty for an early distribution made from her employer’s qualified plan. Although her distribution took place after she attained age 55 years, her separation from service occurred when she was just 53 years old, thus disqualifying her from the age 55 exception. Watson v. Commissioner, (2011-113 (September 28, 2011.)

Rule of 55 Mistakes: Probably the biggest mistake individuals make is assuming that this exception from the penalty applies to the owner of a traditional IRA. Other mistaken assumptions also are frequently made.

Not all Retirement Accounts: An early retiree who looks to take advantage of the age 55 separation-from-service exception will not have it apply to all retirement plans in which he/she participates. If the participant who attains age 55 has multiple qualified plan accounts with multiple different employers, the retiring employee will not be able to access the funds held in the ‘old’ retirement accounts; only from the employer from which the participant is separating from service.

Example: Caroline worked for several years for Ajax Company which sponsored a 401(k) account. After 20 years with Ajax Caroline took a job with Tradeco. Caroline left her retirement account with the Ajax when she left employment (permitted under the Ajax plan) because she like the investment options under the Ajax 401(k) plan. Caroline participated in the Tradeco 401(k) plan for the next 15 years, and now that Caroline as attained age 55 years, she plans to retire from Tradeco. Caroline will be able to access the funds held in her Tradeco 401(k) account with a penalty, but Caroline will not be able to access the funds in her Ajax 401(k) account without incurring a 10% penalty. Note, though, that if the Tradeco plan permitted a rollover of retirement funds from another qualified plan, Caroline could have, prior to her early retirement, emptied her Ajax 401(k) account by transferring (rolling over) those 401(k) Ajax funds to the Tradeco 401(k) plan, and the funds would then have fallen under the age-55 exception applicable to Caroline’s current qualified plan.

IRAs:  As noted, if a plan participant owns a traditional IRA and also a 401(k) account, and that participant separates from service at age 55 from the employer that sponsors the 401(k) plan, he/she may access the 401(k) plan penalty-free, but not the IRA (unless there are other statutory exceptions to apply to accessing the IRA without penalty.)

IRA Rollovers: Another mistake sometimes made by an early retiree is to roll their qualified plan account into a traditional IRA, and then take a distribution from the traditional IRA after age 55-years and their separation from service. As noted, the age-55 exception never applies to IRAs, even if the IRA is funded by a rollover from a qualified plan where the age-55 separation-from-service exception would have been available.

Example: Young, a lawyer, age 56, rolled over the funds from his law firm’s 401(k) plan to an IRA. He then separated his service from the law firm and he withdrew the funds from his rollover IRA. Young was assessed the 10% penalty for an early withdrawal. Young could have completely avoided the penalty (and his subsequent legal fees) had he simply left his retirement funds in the qualified plan and taken the withdrawal from the qualified plan. Young claimed that there should be no 10% penalty assessed since rule of 55 exception applied as the funds came from his 401(k) account and he retired after age 55. The Tax Court held that the rule of 55 exception was no longer available once Young did the rollover to his traditional IRA. Young Kim v. Commissioner, ( Tax Court, 7th Circuit, No. 11-3390, May 9, 2012.)

Conclusion: When a plan participant leaves their employment in anticipation of early retirement, it is critical to proceed with caution before rollover over their qualified plan account to an IRA. A rollover is irrevocable, so there is no way to ‘undo’ the rollover. Attempting to roll the funds back into the qualified plan is likely not to be available as an option if there has been a separation from service.  The rule of 55 is helpful to many who contemplate an early retirement, but it can be complicated to qualify for the rule, and thus it is important for early retirees to understand how the rule works and how it is limited.