How do I include the "Rule of 55" or the "More than 5% Ownership" rule in a plan?

What is the “Rule of 55”?

The “Rule of 55” is an exception to the 10% federal early-distribution penalty for certain employer retirement plans. It can let someone access a workplace retirement plan before age 59½ without the 10% penalty. This rule does not apply to IRAs or funds rolled into an IRA from a workplace plan like a 401(k).

The key requirements are:

• The person must separate from service with the employer during or after the calendar year in which they turn 55.
• The withdrawal must be from that employer's qualified retirement plan, such as a 401(k), 403(b), or other qualified employer plan.
• It does not apply to IRAs, including Traditional, SEP, and SIMPLE IRAs. 
• The distribution is still taxable as ordinary income to the extent it consists of pre-tax money; only the 10% additional tax is waived.
• The employer's plan must actually allow the person to take the distribution. The tax rule doesn't itself require the plan to offer a particular withdrawal option.

You don't actually have to be 55 on the day you leave. For example, suppose someone turns 55 on December 20, 2027:

The IRS describes the rule as separation occurring “during or after the year the employee reaches age 55.”

This also means waiting until 55 to take distributions from a plan doesn't cure an earlier separation. If someone leaves their employer at 53 and then withdraws from that old 401(k) at 56, the Rule of 55 doesn't apply because the separation itself occurred too early. The IRS gives essentially this example in Publication 575.

The exception is tied to an employer plan, not an IRA. So someone who leaves their job at 55 might have:

• Old 401(k) → take distributions directly: Rule of 55 can apply.
• Old 401(k) → roll everything to IRA → take IRA distribution: Rule of 55 no longer applies to that IRA distribution.

That makes the Rule of 55 an important reason not to automatically roll a 401(k) into an IRA when retiring between 55 and 59½.

Conversely, if assets from older plans have already been rolled into the current employer's 401(k) before the qualifying separation, they generally become assets of the current plan and can potentially be accessed under the exception, subject to the plan's distribution rules.

How Income Lab models the Rule of 55

In an Income Lab plan, there are settings at the individual investment account level that allow the software to correctly apply the Rule of 55. To access these settings, click on the “Account and distributions settings” link below the “Account Type” dropdown menu.

If the client is separated from service (you have marked “Do you still work for the employer who sponsors this plan?” as “No”), the settings look like this:

Here you'll see the “Stopped working for this employer in or after the year account owner turned 55” setting. If you set this to “Yes”, the rule of 55 will apply and any withdrawals from this account will be penalty-free. This setting is not available in accounts set to an “IRA” account type. (Of course if the client is not yet age 55, a “yes” answer here will be ignored since there is no way the client could have separated from service at that age.)

If the client is still working for the plan sponsor, you will instead see a “When do you plan to stop working for this employer?” field. The software will use this date to determine if the rule of 55 applies.

The more-than-5% Ownership Rule

Note also that if the client is still working for the plan sponsor, there is a question about whether they will own more than 5% of the sponsor when they reach normal RMD age. 

This question is there to allow the software to apply the “5% ownership RMD” rule, which is an exception to the normal “still working” RMD delay for employer retirement plans. Since Income Lab software automatically models future RMDs, this can be an important setting to use in situations where the client has a sizeable ownership stake in the company and plans to retire after RMD age.

How does the more-than-5 % rule work? "Normally, someone with a 401(k), 403(b), profit-sharing plan, etc. can delay taking or owing RMDs from their current employer’s plan until they actually retire, even if they are already past RMD age. But that delay is not available if they are a more-than-5% owner of the employer sponsoring the plan. In that case, they must begin RMDs based on age, just like an IRA owner, even if they are still working.

For someone whose applicable RMD age is 73, that means:

• ≤5% owner and still working: potentially no RMD from that employer plan until retirement.
• >5% owner: RMDs begin for the year they turn 73, regardless of whether they're still working.
• The first RMD can generally be delayed until April 1 of the following year, although doing so causes two RMDs in that following calendar year. 

For this rule, a person is treated as a 5% owner if, for the relevant plan year, they own or are considered to own:

• more than 5% of the outstanding stock, or
• more than 5% of the voting power, or
• for a noncorporate business, more than 5% of the capital or profits interest.

So someone owning exactly 5.00% is not a “5% owner” for this purpose; 5.01% would be. There are also constructive ownership / attribution rules, so ownership held by certain related people or entities can sometimes be attributed to the employee. A client would generally want to work with a legal and/or tax advisor to determine what rules apply to them.