Rule of 55 - the mechanics

[Boyan]

Hi everyone,

I've read and researched the Rule of 55 extensively but outside of the actual rules nobody talks about the implementation mechanics, how does it work in real life? I find it suspiciously too easy to just file regular taxes and as long as the rules are met - no penalty is levied (completely understanding that 401k distribution is "income" and subject to Fed and State income tax)? The topic here is strictly about the early distribution penalty.

Is there any specific IRS form which is filed with one's taxes to seek the exemption from a 10% early distribution penalty? If there's no form how does IRS actually determine whether you owe a penalty or not? The 401k plan itself does NOT take out penalty upon distributions, only 20% FedTax and for specific states - mandatory State Tax but that's about it. 

Have any of you actually done this and if yes please share your experience and how it worked for you?

PS. Does TurboTax detect when 401k 1099 is used and trigger some kind of interview questionnaire around the penalty piece?

Thank you

Boyan

[tagteam]

@dmertz 

[TomD8 · Accepted solution]

If you receive an early distribution from a 401K, then Box 7 of your 1099-R should show a Distribution Code of 1 or 2.

This is how the IRS (and TurboTax) know that the distribution was early.

See page 15 of this IRS Publication:

https://www.irs.gov/pub/irs-pdf/i1099r.pdf

[Boyan]

@TomD8 Thank you so much Tom! That's super clear. Ok so then what? How does the process continue? TubroTax fires an interview process to determine whether penalty is due or not? What are the mechanics of determining the penalty question? Thank you!

[VolvoGirl]

Exceptions for Early Distributions from a Qualified Retirement Plan such as a 401(k) or 403(b) plan. See Pub 575 page 36 Additional Exceptions
https://www.irs.gov/pub/irs-pdf/p575.pdf

..Distributions upon the death or disability of the plan participant.
..You were age 55 or over in the year you retired or left your job. (50 for qualified public safety employees)
..You received the distribution as part of "substantially equal payments" over your lifetime.
..You paid for medical expenses exceeding 7.5% of your adjusted gross income.
..The distributions were required by a divorce decree or separation agreement ("qualified domestic relations court order"),

The questions about exceptions to the penalty do not come after entering the 1099-R. Rather, you will see that area after you have finished all the Deductions and Credits section.

[dmertz · Accepted solution]

To expand on what TomD8 and VolvoGirl said, normally the 401(k) plan will know your age and separation date so that they can code the Form 1099-R with code 2 if you qualify for this exception.  TurboTax and the IRS know to treat code 2 as indicating that there is no early-distribution penalty on this distribution.  If the plan uses code 1 instead, you can still file Form 5329 Part I and claim on line 2 a code 01 exception to the penalty.  As you continue through TurboTax's step-by-step mode TurboTax will offer several options for penalty exceptions but won't offer this particular exception if you have not yet reached age 55.  (Despite having sufficient information to determine that you do not qualify for the exception, TurboTax does not flag an error if you make the entry in forms mode.)

It's up to the IRS whether or not to question your use of any particular exception claimed on Form 5329 and might request supporting documentation.  If you claim a code 01 exception and you have not yet reached age 55, the IRS is likely to disallow the exception.  Similarly, if you claim a code 01 exception but your distribution is from an IRA, the IRS is likely to disallow the exception because this exception does not apply to IRAs.

[Boyan]

Found it! Thank you!