If you take funds from an IRA or other retirement plans before you are age 59 ½, not only do you have to pay the taxes on the distribution, you will also be subject to a 10% early distribution penalty on the distributed amount. One of the many exceptions to the 10% early withdrawal penalty is separation from service from an employer plan in the year the employee turns age 55 or later. This rule is not as clear as some people may think. The key is that the employee must separate from service in the year they turn age 55 or later, not when the distribution is made. Gail Marie Watson found this out the hard way in her fight with the IRS which she unquestionably lost.
In this case, the taxpayer took the distribution after attaining the age of 55 however she had separated from service at only age 53 and thus did not qualify for the exception. The court ruled that the "law is clear;" it is the date of separation from service that is the determining factor, not the age of the distribution.
3 Common Age 55 Exception Mistakes:
1. Separating from service prior to age 55
As the Watson case shows, separation must occur in the year the taxpayer turns age 55 or later. This rules seems to indicate that the person must actually be 55 to be eligible for the exception however this is not the case. The devil is in the details; the separation must occur in the year the person turns 55. This means that separation can occur when the individual is only age 54 as long as they will reach age 55 in that calendar year. This also means that the distribution itself can occur before reaching age 55 as long as the individual turns age 55 that year. For example, if you separate from service on 3/1/2012 when you are age 54, took a distribution from the plan on 6/1/2012, and then turned age 55 on 12/1/2012, you would qualify for the exception.
2. Taking funds from a different retirement account
The age 55 exception only applies to a plan where the individual has separated from service from the plan. Distributions from IRAs (including SEP & SIMPLE IRAs) never qualify for this exception and distributions from other employer plans will only qualify if the individual separated from service from that plan in the year they turned age 55 or later.
3. Rolling over plan funds to an IRA
The age 55 exception only applies to employer plans where eligible, not IRAs as indicated in item #2 above. If you qualify for this exception and then rollover your balance to an IRA, the exception is lost and there is no way to fix this. So if you separate from service from your employer in the year you turn age 55 but before you are age 59 ½, you might consider waiting to rollover the funds until you are age 59 ½ just in case you need some of the money.