Separation from Service Rule and the 10 Percent Additional Tax Penalty
How to Protect Your Retirement Savings from Penalties
The separation of service rule is often overlooked in the qualified retirement planning. Most people are familiar with the age 59½ rule that allows an individual to begin receiving distributions from a retirement plan OR an IRA account without any 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.
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 a recent Tax Court case, Catania v. Commissioner, T.C. Memo. 2021-33, a taxpayer who was employed at Home Depot and participated in their 401(k) plan retired during the year he turned age 55. He transferred the 401(k) plan fund into a traditional IRA account. Two years later, the taxpayer, who had not reached age 59½, took a distribution from the IRA for various home improvements and maintenance. The taxpayer reported the IRA distribution on his income tax return but did not include the 10 percent additional penalty for early distribution.
The IRS assessed the ten percent penalty and the taxpayer filed a petition. The court held that the separation of service rule does not apply to IRA accounts, only qualified retirement accounts. Even though the taxpayer separated from service during the year of turning age 55 and the IRA funds came from the qualified retirement account, the separation from service exception only applies to distribution made from qualified retirement accounts, and not IRAs.
If you are age 55 or older with retirement plan assets and considering retirement, ask yourself the following question: “Will I have a need for a distribution prior to turning age 59½?”
If the answer is yes or maybe, reach out to your Cherry Bekaert professional for guidance to prevent any unforeseen additional taxes related to a retirement plan withdrawal.