What is the Rule of 72t and 55 and how it affects early retirees?
Oftentimes individuals retire earlier than they had originally anticipated. We have discussed this in previous blogs because whether it comes by choice or force, retiring early impacts several aspects of retirement planning. Retiring early can lead to a higher cost of private healthcare coverage before Medicare, as well as a depletion of portfolio assets early on in retirement and excess taxes. Approaching retirement, clients often have a majority of their wealth tied up in some type of retirement plan like a 401k or 403b, and once their employment ends, they have three options for what to do next. They can keep the plan where it is, roll it into a new 401k if the plan allows, or they can roll it into an IRA with the broker/dealer or custodian of their choice. However, there is usually a 10% penalty for withdrawals prior to age 59 ½, unless the client takes advantage of an overlooked option with the rule of 72(t) or rule of 55 early distributions.
First, let’s distinguish between the rule of 72(t) and the rule of 55. The rule of 72(t) allows penalty-free withdrawals from an IRA and other retirement accounts like a 401k and 403b. However, there are some restrictions. While withdrawals may still be taxed as ordinary income, they can avoid the 10% penalty for withdrawals under age 59 1/2. In order to qualify as a 72(t) distribution, the employee must take at least 5 substantially equal periodic payments (SEPP) that are calculated either on the required minimum distributions method, the amortization method, or the annuitization method based on certain life expectancy tables and calculations. These payments must occur over at least 5 years or until the retiree reaches 59 ½, whichever is longer.
Now let’s discuss the rule of 55. This rule is different and only applies to old plans like a 401k or 403b and not an IRA. It is an IRS guideline exception also allowing avoidance of a 10% penalty for early withdrawal but only if you leave your job after you turn 55 or often times even at 50 if you are a public service employee like EMS, Police, Firefighter, etc. The term is broad so that can be applied if an individual is laid off or if they decide to leave early after age 55. However, it does depend on the terms of the retirement plan, so it is important to check on the language with the plan administrator as certain plans do not allow for its application. Rule of thumb suggests that if you have old 401ks, you should look into rolling those into a current 401k. You would want to access the funds from a current account if you had to leave your job early, otherwise the rule of 55 will not apply.
Other penalty avoidance rules can include long-term disability or medical expenses in excess of 7.5% of adjusted gross income (AGI), as well as certain other hardships. What is nice about this rule of 55 compared to the rule of 72(t) is that it provides more flexibility and employees can decide (on their own terms) the amounts and frequency of withdrawals.
Another option if facing an unexpected early retirement could be supplementing income with part time work to reduce the amount pulled from your assets. Avoid depleting assets used for retirement prior to retirement unless absolutely necessary. If you were one of our financial planning clients, we would create the best scenario for your retirement given any life changes. Financial planning is an ongoing process and a blueprint for success. As goals change or circumstances change, we can adjust your financial plan and still help you achieve financial success in retirement.
Matthews Barnett, CFP®, ChFC®, CLU®
Financial Planning Specialist