Navigating Rule 55: Understanding Separation Procedures for Target Employees

When preparing for a qualified retirement, the separation of service rule 55 is frequently ignored. Most people are aware of the age 59½ rule, which waives the 10% early withdrawal penalty and permits a person to start taking distributions from an IRA or retirement plan at any time.

According to the separation of service rule, withdrawals from a business-sponsored retirement plan, like a 401(k) plan, are not subject to an additional 10 percent tax penalty if an employee quits the company during the year that they become 55 or older.

Employees with Target-sponsored retirement accounts, such 401(k)s, who choose to retire early or require access to the money in the event of a job loss close to the conclusion of their career, may find benefits from the Separation from Service exception. For Target employees who depend on financial flow and have no viable other options, it may be their only hope.

Here’s how the Separation from Service exception works and whether you should consider using it.

What is the  Separation from Service exception (55 Rule) ?

Once an employee reaches the age of 55, they are eligible to begin receiving penalty-free payments from their current employer's retirement plan under the terms of the IRS "Rule of 55" or "Separation from Service exception." It allows Target employees to collect earlier than usual retirement plan payments, which is advantageous for people who need the extra cash flow or want to retire earlier than usual.

If a distribution is taken out of a tax-qualified retirement plan, like a 401(k), before the age of 59 ½, there is usually an early withdrawal tax penalty of 10%. If your Target-sponsored plan permits such distributions, you may be able to receive a payout after turning 55 (but before turning 59 ½) without being subject to the early penalty due to the IRS Separation from Service exception.

Notwithstanding, a twenty percent income tax withholding rate would still apply to any distribution. You will receive a refund following the filing of your annual tax return if it turns out that 20% is less than you owe on the basis of your total taxable revenue.

For example: In one Tax Court case, a 53-year-old taxpayer—who we will refer to as Nancy—quit her employment. Nancy was qualified to receive a payout from her employer plan upon her separation from service. Distributions to terminated employees (aged 55 and over) were also permitted under the arrangement. When Nancy quit her employment, she chose not to accept the distribution; however, after she turned fifty-five, she decided to start receiving them. Nancy most likely believed incorrectly that she would not be subject to the 10% early withdrawal penalty after she turned 55. Since she was under 55 when she left her job, the IRS disagreed and assessed the penalty. The Tax Court decided in favor of the IRS, holding that the taxpayer's age at the time of their separation from service—rather than the date they received the distribution—is what counts. Consequently, the 10% fine was maintained.

One very important difference between the separation of service exception and the age 59½ rule is that the separation of service exception only applies to qualified retirement plans and not IRA accounts.

In another court case , Robert, a taxpayer, rolled over his balance from a qualifying plan into his IRA after quitting his work at age 55. After then, Robert started receiving payments from the IRA. The Court sided with the IRS during the trial, ruling that the early withdrawal penalty applied to the later distribution and that it was not covered by the Separation from Service provision. Thus, you should exercise caution when rolling over money into an IRA if you quit your work after turning 55 and require all or some of your retirement savings right away. The Rule of 55 exception disappears when qualifying plan assets are rolled over into an IRA. Unless there is an exemption, any further withdrawals from the IRA made before the age of 59½ will be penalized 10% for early withdrawal.

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How to use the rule of 55 to retire early

Target might not have the option, but many businesses do have retirement plans that let workers benefit from the Separation from Service exemption.

Don't be shocked if your Target-sponsored plan does not permit withdrawals under the Separation from Service exception; 401(k) and 403(b) plans are not obligated to provide this feature. Many employers view this provision as an inducement for workers to leave in order to receive a penalty-free payout, which may have the unintended consequence of causing workers to use down their retirement funds too soon.

Here are the conditions that must be met and other things to consider before taking a Separation from Service exception withdrawal.

• Retirement plan offers them. Target’s plan offers a 401(k) or 403(a) or (b) that allows Separation from Service exception withdrawals. Some plans prohibit withdrawals prior to age 59 ½ or even 62.
• Age 55 or older. You leave your position (voluntarily or involuntarily) at Target in or after the year you turn 55 years old.
• Money must remain in the plan. You fully understand that your funds must be kept in Target’s plan before withdrawing them and you can only withdraw from Target’s plan. If you roll them over to an IRA, you lose the rule of 55 tax protection.
• Potential lost gains. You understand that taking early withdrawals means forfeiting any gains that you might otherwise have earned on your investments.
• Reduce taxes. You can wait until the start of the next calendar year to begin rule of 55 withdrawals when your taxable income should be lower if you are not working.
• Public safety worker. If you are a qualified public safety worker (police officer, firefighter, EMT, correctional officer or air traffic controller), you might be able to start five years early. Make sure you have a qualified plan that allows withdrawals in or after the year you turn 50 years old.

However, as with any financial decision, be sure to check with a trusted advisor or tax professional first to avoid any unforeseen consequences.

Should you use the  Separation from Service exception ?

Your particular financial situation will determine whether or not you should take early withdrawals under the Separation from Service exception. After leaving Target, you should be well aware of the terms of your plan, the amount you would need to withdraw, and the expected annual expenditures you will incur. You should be able to determine whether making an early withdrawal is the appropriate move for you by resolving those issues.

Here are some situations where it’s likely that taking early withdrawals would not be the right move.

• If it would push you to a higher tax bracket. The amount of your income for the year in which you begin the withdrawal plus the early withdrawal might put you into a higher marginal tax bracket.
• If you’re required to take a lump sum. Target's plan might require a one-time lump sum withdrawal, which may force you to take more money than you want and subject you to ordinary income tax liability. These funds will no longer be available as a source of tax-advantaged retirement income.
• If you’re younger than 55 years old. You might want to leave Target before you turn 55 and start taking withdrawals at age 55. Note this is NOT allowed and you will be assessed the 10 percent early withdrawal penalty.

Other important considerations

If you’re thinking of taking a Separation from Service exception withdrawal, you’ll also want to consider a few other things:

• If you have funds in multiple former employer plans, the rule applies only to the plan of your current/most recent employer. If you have funds in multiple plans that you want to access using the Separation from Service exception, be sure to roll over those funds into your Target’s plan (if it accepts rollovers) BEFORE you leave the company.
• Funds from IRA plans that you might want to access early can also be rolled into your current plan (while still employed) and accessed that way.
• If you so choose, you can continue to make withdrawals from your former employer’s plan even if you get another job before turning age 59 ½.
• Be sure to time your withdrawals carefully to create a strategy that makes sense for your financial situation. Withdrawing from a taxable retirement account during a low-income year could save you in taxes, particularly if you believe your tax rate may be higher in the future.
• Bear in mind that the only real advantage of the Separation from Service exception is avoiding the 10 percent penalty. Meanwhile, the tax deferral is sacrificed, which may turn out to be more valuable if other financial resources that are not tax-qualified can cover expenses for the coming years, allowing you to save the 401(k)/403(b) distribution until later years.

Other Exceptions

You may be able to access the funds in your retirement plan with Target without a tax penalty in a few other ways, depending on your circumstances.

The 72(t) option is an exemption that permits penalty-free withdrawals from your 401(k) or IRA at any age. The payment plan known as SEPP (Substantially Equal Periodic Payments) does not impose the 10% early withdrawal penalty. These distributions have to start and stay that way for five years, or until you turn fifty-nine-five, whichever comes first. All of a sudden, 72(t) payments became a better option for participants in workplace plans and owners of IRAs.

72(t) payments, sometimes referred to as "substantially equal periodic payments," are beneficial since they are not subject to the 10% early distribution penalty that is typically imposed on withdrawals made before the age of 59 ½. They are withdrawable from an IRA at any moment, but only from a workplace plan following your departure from Target.

There are several downsides to 72(t) payments.

•  First, they must remain in place for at least 5 years or until age 59 ½, whichever comes later. This means a 45-year old IRA owner must maintain her payments for almost 15 years.
• Second, if the payments are modified before the end of the 5-year/age 59 ½ duration, you are subject to a 10% penalty (plus interest) on all payments made before 59 ½. Modification will normally occur if you change the payment schedule (e.g., stop payments), change the balance of the account from which payments are being made (e.g., a rollover to the account), or change the method used to calculate the payment schedule (except for a one-time switch to the RMD method – see below).

There are three(3) acceptable ways to calculate 72(t) payments:  

• The required minimum distribution (RMD) method.  Payments are calculated like lifetime RMDs. Therefore, they fluctuate each year. The RMD method normally produces the smallest payout among the three methods. Once you use the RMD method, you can’t switch out of it.
• The fixed amortization method.  Payments are calculated like fixed mortgage payments. After using this method for at least one year, you can switch to the RMD method without penalty.
• The fixed annuitization method.  Payments are calculated by dividing the account balance by an annuity factor. Like the amortization method, they remain fixed, and you can switch to the RMD method after the first year.

On the other hand, the IRS published Notice 2022-6 on January 18, stating that interest rates up to 5% may be applied to 72(t) payment plans beginning in 2022 or later. (In addition, you may use a rate up to 120% if the Federal mid-term rate increases over 5%.) This is excellent news since it means that payments will increase if interest rates rise. You can now make larger installments from the same IRA balance thanks to this modification. (Take note that interest rates cannot be altered for a series of 72(t) payments that have already been made.)

Other circumstances that exempt you from the early withdrawal penalty include:

• Total and permanent disability
• Distributions made due to qualified disasters
• Certain distributions to qualified reservists on active duty
• Medical expenses exceeding 10 percent of adjusted gross income
• Withdrawals made to satisfy IRS obligations

But the IRS offers other exceptions to the early withdrawal penalty.

Bottom line

If you can wait until you turn 59 ½, withdrawals after that age are not typically subject to the 10 percent IRS tax penalty. However, if you are in a financially safe position to retire early, the Separation from Service exception may be an appropriate course of action for you.