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Separation From Service Rule 55: Explained for University of Chicago Employees

It is essential for University of Chicago employees who are thinking about early retirement to find out more about the specifics of the Separation from Service exception in order to make the best financial decision. As Tyson Mavar from The Retirement Group, a division of Wealth Enhancement Group, recommends, workers should take these rules into consideration and meet with a qualified advisor to ensure that their finances are well positioned,” suggests Patrick Ray, Financial Advisor.

“Understanding the basics of early retirement options like the Separation from Service exception is crucial for University of Chicago employees. Patrick Ray from The Retirement Group, a division of Wealth Enhancement Group, explains the significance of consulting with a qualified professional in order to ensure that these financial strategies are implemented correctly in order to achieve the best results,” says Michael Corgiat, Retirement Specialist.

In this article, we will discuss:

1. The specifics of the Separation from Service rule, also known as the Rule of 55, which allows employees to take penalty-free withdrawals from their 401(k) plans starting at age 55 under certain conditions.
2. The key differences between the Separation from Service rule and the standard age 59½ rule, including the restrictions and limitations of each.
3. Practical considerations and examples that illustrate how the Separation from Service exception can be used to plan for early retirement or to meet certain financial needs if one loses a job.
The separation of service rule 55 is not fully discussed in the qualified retirement planning. Most people are probably aware of the age 59½ provision that permits a person to receive distributions from a retirement plan or an IRA account without incurring a 10 percent early withdrawal penalty.

The separation of service rule states that if an employee, who is participating in a company retirement plan such as a 401(k) plan, leaves the employer during the year in which they turn age 55 or older, distributions from the retirement plan are not subject to the additional 10 percent tax penalty.

The Separation from Service exception can help workers who have a University of Chicago-sponsored retirement account, such as a 401(k), and want to retire early or need to withdraw funds if they have lost their job towards the end of their career. It can be a lifeline for University of Chicago workers who require cash flow and have no other good alternatives.

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)?

The Separation from Service exception sometimes called “Rule of 55” or “55 Rule” is an IRS provision that allows workers who leave their job for any reason to start taking penalty-free distributions from their current employer’s retirement plan once they’ve reached age 55. It offers University of Chicago employees, who are interested in retiring earlier than the usual age or who need the funds, a way to take distributions from their retirement plans before the age of 59½.

Taking a distribution from a tax-qualified retirement plan, such as a 401(k), before the age of 59½ is generally subject to a 10 percent early withdrawal tax penalty. However, the IRS Separation from Service exception may permit you to receive a distribution after reaching age 55 (and before age 59½) without triggering the early penalty if your University of Chicago sponsored plan permits such distributions.

However, any distribution would still be subject to an income tax withholding rate of 20 percent. If it turns out that 20 percent is more than you owe based on your total taxable income, you’ll get a refund after filing your yearly tax return.

For example: In one Tax Court case, a taxpayer, whom we will call Nancy, left her job when she was 53 years old. Under the terms of her company plan, Nancy was eligible to take a distribution upon separation from service. The plan also allowed distributions to terminated employees, age 55 and above. Nancy declined to take the distribution when she left her job but elected to begin distributions once she turned 55. Undoubtedly, Nancy was under the mistaken impression that once she turned age 55, she was exempt from the 10% early withdrawal penalty.

The IRS disagreed and imposed the penalty since she was not age 55 when she was terminated from service. The Tax Court sided with the IRS and ruled that what matters is the age of the taxpayer when they separated from service, not when they took the distribution. Therefore, the 10% penalty was upheld.

The main 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, a taxpayer, Robert, left his job at age 55 and rolled over his balance from a qualified plan to his IRA. Robert then began taking distributions from the IRA. At trial, the Court sided with the IRS and held that the subsequent distribution did not fall under the Separation from service exception and was subject to the early withdrawal penalty. Therefore, if you leave a job after turning age 55 and need all, or a portion, of your retirement funds immediately, you should be careful about rolling over funds into an IRA. Once you roll over qualified plan assets into an IRA, the Rule of 55 exception is lost. Any subsequent distributions from the IRA before age 59½ will be subject to the 10% early withdrawal penalty unless another exception applies.

How to use the rule of 55 to retire early

Many companies have retirement plans that enable employees to take advantage of the Separation from Service exception, but University of Chicago may not offer the option.

401(k) and 403(b) plans are not required to provide for Separation from Service exception withdrawals, so you shouldn’t be surprised if your University of Chicago-sponsored plan doesn’t allow for this exception. Many companies see the rule as an incentive for employees to resign in order to get a penalty-free distribution, with the unintended consequence of prematurely depleting their retirement savings.

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

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Retirement plan offers. If the University of Chicago plan offers a 401(k) or 403(a) or (b), the Separation from Service exception withdrawals are allowed. Some plans prohibit withdrawals prior to age 59½ or even 62.

Age 55 or older. You leave your position (voluntarily or involuntarily) at University of Chicago 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 the University of Chicago plan before withdrawing them and you can only withdraw from the University of Chicago 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 you will be giving up any gains you might have been able to make 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. Ensure that 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?

Whether or not to take early withdrawals under the Separation from Service exception will depend on your financial situation. You’ll want to know your plan’s rules, how much you’d need to withdraw, and what your annual expenses are likely to be in the early years of your early retirement after leaving University of Chicago. Solving those issues should help you know if taking an early withdrawal is the right decision for you.

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. The University of Chicago plan may require a one time lump sum withdrawal and this may force you to take more money than you want and be subject 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 University of Chicago 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 only applies 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 University of Chicago 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 59½.

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 and you are able 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 University of Chicago without a tax penalty in a few other ways, depending on your circumstances.

There is an exception called the 72(t) option which allows withdrawals from your 401(k) or IRA at any age without any penalty. This option is called SEPP (Substantially Equal Periodic Payments), and these payments are not subject to the 10 percent early withdrawal penalty. Once these distributions begin, they must continue for a period of five years or until you reach age 59½, whichever comes later. 72(t) payments have suddenly become a better deal for IRA owners and company plan participants.

Also known as “substantially equal periodic payments,” 72(t) payments are advantageous because they are exempt from the 10% early distribution penalty that usually applies to withdrawals before age 59½. You can take them from an IRA at any time, but only from a workplace plan after leaving University of Chicago.

There are several downsides to 72(t) payments.

First, they must remain in place for at least 5 years or until age 59½, 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 59½ duration, you are subject to a 10% penalty (plus interest) on all payments made before 59½. 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.

However, on January 18, the IRS released Notice 2022-6, which said that 72(t) payment schedules starting in 2022 or later can use an interest rate as high as 5%. (And, if 120% of the Federal mid-term rate rises above 5%, you can use a rate as high as the 120% rate.) This is still the updated rate in 2024. This is great news because the higher the interest rate, the higher the payments will be. This change allows you to squeeze higher payments out of the same IRA balance. (Note that you can’t change interest rates for a series of 72(t) payments already in place.)

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

1. Total and permanent disability

2. Distributions made due to qualified disasters

3. Certain distributions to qualified reservists on active duty

4. Medical expenses exceeding 10 percent of adjusted gross income

5. 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 59½, 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.

Sources:

1. Brenner, Sarah. '5 Things You Must Know about the Age-55 Rule.' Ed Slott and Company, LLC , 23 June 2021, irahelp.com.

2. 'Understanding the Age 55 Exception to the 10% Early Withdrawal Penalty.' The Money Know How , themoneyknowhow.com.

3. 'Retiring Early? 5 Key Points about the Rule of 55.' Charles Schwab , 12 March 2024, schwab.com.

4. 'Retirement Plan: Separation from Service Rule & Tax Penalty.' Cherry Bekaert , cbh.com.

5. Liang, Eddie. 'Retirement Planning Between Ages 55 & 59.5: The Rule of 55.' Downshift Financial , 21 September 2021, downshiftfinancial.com.

What are the eligibility criteria for participation in the SEPP plan for employees of The University of Chicago, and how can factors like years of service and age impact an employee's benefits under this plan? Discuss how these criteria might have changed for new employees post-2016 and what implications this has for retirement planning.

Eligibility Criteria for SEPP: Employees at The University of Chicago become eligible to participate in the SEPP upon meeting age and service requirements: being at least 21 years old and completing one year of service. For employees hired after the plan freeze on October 31, 2016, these criteria have been crucial in determining eligibility for newer employees, impacting their retirement planning as they do not accrue benefits under SEPP beyond this freeze date.

In what ways does the SEPP (Staff Employees Pension Plan) benefit calculation at The University of Chicago reflect an employee's years of service and final average pay? Examine the formulas involved in the benefits determination process, including how outside factors such as Social Security compensation can affect the total pension benefits an employee receives at retirement.

Benefit Calculation Reflecting Service and Pay: The SEPP benefits are calculated based on the final average pay and years of participation, factoring in Social Security covered compensation. Changes post-2016 have frozen benefits accrual, meaning that current employees’ benefits are calculated only up to this freeze date, affecting long-term benefits despite continued employment.

How can employees at The University of Chicago expect their SEPP benefits to be paid out upon their retirement, especially in terms of the options between lump sum distributions and annuities? Analyze the advantages and disadvantages of each payment option, and how these choices can impact an employee's financial situation in retirement.

Payout Options (Lump Sum vs. Annuities): Upon retirement, employees can opt for a lump sum payment or annuities. Each option presents financial implications; lump sums provide immediate access to funds but annuities offer sustained income. This choice is significant for financial stability in retirement, particularly under the constraints post the 2016 plan changes.

Can you elaborate on the spousal rights associated with the pension benefits under the SEPP plan at The University of Chicago? Discuss how marital status influences annuity payments and the required spousal consent when considering changes to beneficiary designations.

Spousal Rights in SEPP Benefits: Spouses have rights to pension benefits, requiring spousal consent for altering beneficiary arrangements under the SEPP. Changes post-2016 do not impact these rights, but understanding these is vital for making informed decisions about pension benefits and beneficiary designations.

As an employee nearing retirement at The University of Chicago, what considerations should one keep in mind regarding taxes on pension benefits received from the SEPP? Explore the tax implications of different types of distributions and how they align with current IRS regulations for the 2024 tax year.

Tax Considerations for SEPP Benefits: SEPP distributions are taxable income. Employees must consider the tax implications of their chosen payout method—lump sum or annuities—and plan for potential tax liabilities. This understanding is crucial, especially with the plan’s benefit accrual freeze affecting the retirement timeline.

What resources are available for employees of The University of Chicago wishing to understand more about their retirement benefits under SEPP? Discuss the types of information that can be requested from the Benefits Office and highlight the contact methods for obtaining more detailed assistance.

Resources for Understanding SEPP Benefits: The University provides resources for employees to understand their SEPP benefits, including access to the Benefits Office for personalized queries. Utilizing these resources is essential for employees, especially newer ones post-2016, to fully understand their retirement benefits under the current plan structure.

How does The University of Chicago address benefits for employees upon their death, and what provisions exist for both spouses and non-spouse beneficiaries under the SEPP plan? Analyze the specific benefits and payment structures available to beneficiaries and the conditions under which these benefits are distributed.

Posthumous Benefits: The SEPP includes provisions for spouses and non-spouse beneficiaries, detailing the continuation or lump sum payments upon the death of the employee. Understanding these provisions is crucial for estate planning and ensuring financial security for beneficiaries.

What factors ensure an employee remains fully vested in their pension benefits with The University of Chicago, and how does the vesting schedule affect retirement planning strategies? Consider the implications of not fulfilling the vesting criteria and how this might influence decisions around employment tenure and retirement timing.

Vesting and Retirement Planning: Vesting in SEPP requires three years of service, with full benefits contingent on meeting this criterion. For employees navigating post-2016 changes, understanding vesting is crucial for retirement planning, particularly as no additional benefits accrue beyond the freeze date.

Discuss the impact of a Qualified Domestic Relations Order (QDRO) on the SEPP benefits for employees at The University of Chicago. How do divorce or separation proceedings influence pension benefits, and what steps should employees take to ensure compliance with a QDRO?

Impact of QDROs on SEPP Benefits: SEPP complies with Qualified Domestic Relations Orders, which can allocate pension benefits to alternate payees. Understanding how QDROs affect one’s benefits is crucial for financial planning, especially in the context of marital dissolution.

How can employees at The University of Chicago, who have questions about their benefits under the SEPP plan, effectively communicate with the Benefits Office for clarity and assistance? Specify the various communication methods available for employees and what kind of information or support they can expect to receive.

Communicating with the Benefits Office: Employees can reach out to the Benefits Office via email or phone for detailed assistance on their SEPP benefits. Effective communication with this office is vital for employees to clarify their benefits status, particularly in light of the post-2016 changes to the plan.