If you’re thinking about early retirement, it may be important for you to understand the Rule of 55 for 401(k) plans.
This IRS rule allows you to withdraw from your 401(k) penalty-free if you are laid off, fired or resign from your job starting in the year you celebrate your 55th birthday.
In this article, I’ll explain how the Rule of 55 works and whether it’s a good idea for you to use it.
Table of Contents
- What Is the Rule of 55?
- How To Use the Rule of 55 To Fund Your Early Retirement
- Should You Take Advantage of the Rule of 55?
- Rule of 55 Alternative: Substantially Equal Periodic Payments (SEPP)
- Other 401(k) Early Withdrawal Exceptions
What Is the Rule of 55?
If you want to retire early, you may wonder: What is the earliest age you can withdraw money from your 401(k) without penalty?
Normally, if you withdraw from a 401(k) or IRA (Individual Retirement Account) before turning 59½, you’ll owe the IRS a 10% early withdrawal tax penalty. And that’s a pretty big incentive to avoid withdrawing those funds early.
However, there are several exceptions to the 59½ withdrawal age. Perhaps the most notable is called the “Rule of 55.”
If you leave your job during or after the year you turn 55, you’re eligible to take early withdrawals from that job’s 401(k) plan.
You can leave your job for any reason (voluntarily or not) and you will still be eligible to withdraw via the Rule of 55.
However, there are some stipulations.
Limitations of the Rule of 55
What are those stipulations? The Rule of 55:
- Applies to 401(k) plans (and equivalent 403 and 408 plans). IRAs aren’t eligible for early withdrawals via the Rule of 55.
- Works only with the retirement plan at your most recent job. If you have other 401(k)s, you won’t be able to withdraw from them penalty-free under the Rule of 55. You’ll need to wait until you’re 59½.
- Doesn’t obligate employers to offer early distributions. Your 401(k) plan can grant you early withdrawals via the Rule of 55, but it doesn’t have to do so. Your company can’t hold your money hostage, but it can decide to pay you via a one-time lump sum if you want to withdraw early. So check with your plan administrator. Lump-sum withdrawals can lead to negative tax and investing consequences.
- Doesn’t excuse you from paying income taxes on your 401(k) withdrawals. The Rule of 55 exempts you from paying a 10% early withdrawal penalty. But any money you take out counts as income that you’ll need to report when you do your taxes.
- Includes mandatory withholding for taxes. If you withdraw from a 401(k) before you’re 59½, the IRS will require your company to withhold 20% of your payout for taxes. If that’s more than you owe, you’ll have to wait for your next tax return to get a refund.
Note that, if you’re using the Rule of 55 to withdraw from a Roth 401(k), you’ll owe taxes only on your earnings, not on your contributions.
Rule of 55 Can Be Rule of 50 for Public Safety Employees
If you’re a public safety employee and you meet certain criteria, you may be able to withdraw 401(k) funds penalty-free starting the year you turn 50.
Public safety employees are those who work in the following professions:
- Police officer
- Emergency Medical Technician (EMT)
- Correctional officer
- Air traffic controller
How To Use the Rule of 55 To Fund Your Early Retirement
If you’re interested in making penalty-free withdrawals between the ages of 55 and 59½, make sure you’ve thought through the implications and potential snags.
Here are a few things to think about before you put this plan into motion:
- Make sure your employer supports early withdrawals. Companies don’t have to allow early withdrawals via the Rule of 55.
- Consider rolling any funds you have in an old 401(k) or another retirement plan into your current 401(k). Until you turn 59½, you’ll be able to withdraw penalty-free only from the 401(k) plan at your most recent job. Not all employers accept rollover contributions, especially from retirement plans that aren’t workplace-related.
- Wait at least until the year you turn 55 to leave your job. If you leave or lose your job the year of your 54th birthday, you aren’t eligible for Rule of 55 withdrawals.
- Consider waiting until January the year after you retire to withdraw. Taking money out of your 401(k) adds to your taxable income. So if you retire early, you may want to wait until the start of the next calendar year to withdraw. That way you’re not increasing your taxable income during a year when you’re still earning money from your job.
- You’re allowed to return to part-time or full-time work at another company while continuing to withdraw penalty-free. Once you start using the Rule of 55 to take money out of your most recent 401(k), you’re allowed to start working again. You can still withdraw from your 401(k) without paying a penalty but only from the same 401(k) you’ve been tapping for income.
Should You Take Advantage of the Rule of 55?
As the saying goes, just because you can do something doesn’t mean you should.
It’s generally a good idea to leave your retirement account alone until your 60s. Withdrawing your 401(k) money early can sink your future retirement income. It’s especially harmful if the stock market has a couple of down years while you’re taking early withdrawals.
If you do retire early, one option is to find freelance work or to work part-time before you can start taking Social Security benefits at 62 years old. That way your 401(k) investments have more time to grow. (Money expert Clark Howard strongly recommends you wait to take Social Security benefits as long as you can.)
For most people, withdrawing from a 401(k) plan early isn’t a wise choice. However, there are a couple of potentially valid reasons to use the Rule of 55:
- You’re in a safe position to retire early. If you’re thinking about retiring early and using the Rule of 55 for income, make sure that it’s financially prudent for you to do so. Consider talking to a financial advisor first. Clark recommends finding a fee-only fiduciary willing to get paid hourly. You can find one through the Garrett Planning Network.
- You’re being strategic about your taxes. Withdrawing from a taxable retirement plan during a low-income year for you could save you some tax money. This is especially true if your taxes may be higher in the future when you plan to take withdrawals.
More Information on Rule of 55 Tax Strategy
It’s a great idea to talk to a financial advisor or a Certified Public Accountant (CPA) who specializes in taxes before implementing an early retirement plan.
But there are other potential tax reasons to be strategic with early withdrawals.
The IRS says you must take Required Minimum Distributions (RMDs) from your 401(k) starting at 72 years old. The more money that remains in your 401(k), the higher your RMDs will be each year. That could push you into a higher tax bracket.
It may be better to roll some of your 401(k) into a Roth IRA rather than taking early withdrawals from your 401(k).
You’ll owe immediate taxes on the money you take out of your 401(k) just as you will on any funds you roll into a Roth IRA. With a Roth IRA, you’ll also have to wait five years from the time you transfer funds into your account until you can withdraw them penalty-free — even if you reach age 59½ during that time.
IRS Publication 575 provides more guidance on the Rule of 55.
The tax implications of retirement accounts get complicated fast, so don’t hesitate to ask for professional advice.
Rule of 55 Alternative: Substantially Equal Periodic Payments (SEPP) Compensation
There’s another way that anyone can take penalty-free early withdrawals from their 401(k) account. It’s called Substantially Equal Periodic Payments (SEPP) or 72(t).
A SEPP allows you to withdraw from your 401(k) or IRA at any age without paying a penalty.
SEPP programs do come with their own set of restrictions:
- You must receive annual payouts for five years or until age 59½, whichever comes later. Your withdrawals can be a fixed amount or the amount can vary each year. There are three different ways to calculate SEPP payouts.
- You must stop contributing to your retirement account. You can utilize SEPP compensation with an IRA or a 401(k). If your retirement account is a 401(k), you must no longer work for the company where you set up your SEPP program.
- A SEPP is permanent. Once you commit to a SEPP program, you’re locked in — or else you’ll pay the 10% penalty that you were trying to avoid.
A SEPP can be an alternative to unemployment benefits if you’ve been laid off from a job you’ve had for a long time.
SEPP programs aren’t the answer if you need all of your 401(k) funds to save yourself from bankruptcy or make a large payment, as you’ll be able to access only a portion of your funds annually for at least five years.
At the risk of sounding like a broken record, there are long-term financial implications involved with a SEPP program, so consult with a financial advisor or CPA before you go this route.
Other 401(k) Early Withdrawal Exceptions
There are several other circumstances that will allow you (or your beneficiary) to withdraw from your 401(k) account before you reach 59½ without paying a 10% penalty.
Some of those include:
- Total, permanent disability
- Medical expenses that exceed 10% of your Modified Adjusted Gross Income (MAGI).
- IRS levy
- Qualified disasters
- Qualified military reservists who are called to active duty
You’re in charge of your finances. You know your personal circumstances and goals better than anyone. If you’re in a position to reasonably retire early and fund your life through early 401(k) withdrawals, great.
For many people, taking money out of your 401(k) early is a bad idea. Please talk to a financial advisor as well as the retirement plan administrator at your current company before you commit to relying on the Rule of 55.