Rule of 55 vs. Section 72(t): Which Is Better for Early 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:
They purchase a first home (withdrawals are limited to $10,000)
They pay health insurance premiums while unemployed.
They are totally and permanently disabled.
They need to cover qualified higher education expenses.
They are paying unreimbursed medical expenses.
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.”
