Close Close
Sign In
Newsletters
Popular Financial Topics Discover relevant content from across the suite of ALM legal publications From the Industry More content from ThinkAdvisor and select sponsors Investment Advisor Issue Gallery Read digital editions of Investment Advisor Magazine Tax Facts Get clear, current, and reliable answers to pressing tax questions
Luminaries Awards
Podcast Center Video Center Webcasts Resource Center Events
About ThinkAdvisor Contact Us Advertise With Us Asset & Logo Licensing Sitemap Terms of Service Privacy Policy Copyright © 2024 ALM Global, LLC. All Rights Reserved.
ThinkAdvisor
Question mark made of money

Retirement Planning > Saving for Retirement > 401(k) Plans

Rule of 55 vs. Section 72(t): Which Is Better for Early Withdrawals?

By Lloyd Lofton

X
Your article was successfully shared with the contacts you provided.

What You Need to Know

  • Your client may not know that there are ways to tap retirement accounts early without penalty.
  • The Rule of 55 has far more flexibility than 72(t) payments.
  • Talk to your client about other options to find needed cash.

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.

  1. They have to leave their job in or after the year they turn 55, whether by retiring, quitting or being fired.
  2. They can’t roll the money in their plan to an IRA before making withdrawals.
  3. The rule can only apply to the plan for their most recent employer.
  4. They’ll be subject to a 20% income tax withholding on distributions.
  5. 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:

  1. Required minimum distribution method.
  2. Amortization method.
  3. 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.

The main benefit is flexibility. The Rule of 55 allows 401(k) withdrawals in any amount. Withdrawals under Section 72(t) must be calculated using one of the three IRS-approved methods.

SOSEPPs must be taken continuously for five years or until the taxpayer turns 59.5, whichever occurs later. The Rule of 55 allows your client the option to take money out the year they turn 55 and then not take anything else out until they turn 60. 

There are strict rules for SOSEPPs that can trigger steep penalties if violated. Many advisors consider this a last-ditch strategy for clients short on cash. Here is an in-depth look at SOSEPPs, and here are some tips for making the most of Section 72(t) and avoiding costly errors.

But the Rule of 55, of course, comes with a big catch: It only applies to workplace retirement plans, and not all plans allow it. If your client does not have access to such a plan, 72(t) withdrawals may be an option.

Other Alternatives

If your client can find an alternative to withdrawing retirement assets early, they can continue to earn compound interest on their assets. They may want to consider tapping a taxable account or taking a home equity loan.

But if they must tap their retirement accounts, there are other penalty-free options for certain situations.

Starting in 2024, workplace retirement plans and IRAs will allow emergency withdrawals up to $1,000 a year under the Setting Every Community Up for Retirement Enhancement (Secure) 2.0 Act.

The act created several other penalty-free withdrawal options that will become available in the next few years.

For clients intending to take an IRA distribution, there are some exceptions to the 10% early withdrawal rule, separate from Rule 72(t). They can take a penalty-free withdrawal if:

  1. They purchase a first home (withdrawals are limited to $10,000)
  2. They pay health insurance premiums while unemployed.
  3. They are totally and permanently disabled. 
  4. They need to cover qualified higher education expenses.
  5. They are paying unreimbursed medical expenses.
  6. They are a qualified reservist who is called to active duty.

Qualified plans have their own list of exceptions, including some of the cases discussed here.

As a trusted advisor, it’s your job to present all of the options for withdrawing money from their clients 401(k) or IRA to help them determine the most tax-efficient solution for their situation. 

Lastly, it’s important to note that if your client has a 401(k) loan at the time they leave their job, the balance would be due in full, otherwise, the total amount is treated as a taxable distribution and a 10% penalty may also apply.

It’s not just what you earn, it’s what you keep that counts, right?

Whether your client uses the Rule of 55, Rule 72(t) or something else, it’s really all about security and certainty.

You can help your clients start being happy with a good rate of return that serves their goals and their lifestyle.

Lloyd Lofton is the founder of Power Behind the Sales and the author of “The Saleshero’s Guide To Handling Objections.”

NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.