The job of advisors and agents is to provide their clients with usable, impactful and relevant planning guidance.
One crucial area of guidance: What if your client needs to start retirement withdrawals before age 59 1/2? They may not know that there are ways to do so without incurring the wrath of the IRS.
If you have a client who is saving in an IRA, they could apply IRS Rule 72(t) — setting up a series of substantially equal periodic payments — for early withdrawals, while there are some clients for whom the Rule of 55 might be more appropriate.
There are some important differences to know when deciding whether to use the Rule of 55 or Rule 72(t).
What Is the Rule of 55?
The Rule of 55 allows clients penalty-free distributions from their workplace retirement plan at age 55, as long as they've left their job.
A client who wants to retire at 55 could take money out of their 401(k) with no worry about the 10% early withdrawal penalty.
A few stipulations apply to those using this rule.
- They have to leave their job in or after the year they turn 55, whether by retiring, quitting or being fired.
- They can't roll the money in their plan to an IRA before making withdrawals.
- The rule can only apply to the plan for their most recent employer.
- They'll be subject to a 20% income tax withholding on distributions.
- Finally, their plan has to allow them to use the Rule of 55 to take money out early.
Not all 401(k)s or 403(b) plans offer employees this option.
What Is 'Rule' 72(t)?
"Rule" 72(t) is actually a section of the IRS tax code (not a rule) related to early distributions from tax-advantaged plans.
Section 72(t) allows taxpayers to take penalty-free withdrawals from an IRA, 401(k) or 403(b) when they're made as a series of substantially equal periodic payments (SOSEPP).
A distribution qualifies as penalty-free if payments are taken for a period of five years or until they turn age 59 1/2, whichever comes later.
Taxpayers are allowed to choose from one of three calculation methods to determine substantially equal periodic payments:
- Required minimum distribution method.
- Amortization method.
- Annuitization method.
The RMD generally yields the lowest amount that can be withdrawn from an IRA or workplace plan.
The amortization method means payments are determined by amortizing the balance of their account over their life expectancy.
Interestingly, annuitization splits the difference.
This means they'd get a fixed payout amount from their plan that's in between what they could get with the amortization method or the RMD method.
Rule of 55 or Section 72(t): Which Is Better?
The Rule of 55 offers a number of benefits over 72(t) withdrawals.
