Retiring Early? Know About the Rule of 55 and Early 401(k) Withdrawals
While we generally advise against taking early distributions (withdrawals) from retirement accounts, exceptions to the rule do exist. Perhaps you’re retiring early and need access to your retirement funds or are facing financial challenges due to job loss or health issues. Regardless of your circumstances, you should familiarize yourself with the rule of 55: a law that can help you avoid IRS fees should you need to access your employer-sponsored retirement account (such as a 401(k) or 403(b)) before reaching typical retirement age—generally after age 59½.
What is the rule of 55?
The rule of 55 is an IRS provision that allows workers who leave their job to withdraw funds from an employer-sponsored retirement account without incurring a penalty, though they must still pay income tax on withdrawals. This rule applies to individuals between age 55 and 59½ and only permits access to funds from one’s current (or most recent) employer’s retirement plan. Qualified public safety workers (e.g., law enforcement officers, EMTs, and firefighters) can take advantage of this rule a little earlier, beginning at age 50. Specific circumstances surrounding one’s departure from a job—whether you quit or were fired/laid off—don’t affect eligibility.
How to use the rule of 55
To take advantage of this provision, you must leave your job after turning 55 (age 50 for public service employees) or during the same calendar year you hit this birthday. You must also have a 401(k) or 403(b) account and ensure your employer allows early withdrawals as not all do. Take time to understand specific rules that apply to your situation, knowing some companies may require you to withdraw the entire amount as a lump sum while others permit a distribution schedule.
Keep in mind that since either option can propel you into a higher income tax bracket, you’ll want to carefully consider the timing of your distribution: perhaps waiting to take an early withdrawal at the start of a new tax year if you have a relatively high income or weighing if this option is even worth pursuing at all, for example.
If you’ve already started taking distributions from your most recent employer’s 401(k) or 403(b), the rule of 55 allows you to continue making withdrawals (even if you get another job) and gaining access to the same 401(k) for distributions while simultaneously participating in your new employer’s retirement plan!
Rule of 55 advantages
You can skirt the 10% early withdrawal fee
Withdrawing funds from your retirement account before age 59½ typically incurs a 10% early withdrawal penalty from the IRS. The primary advantage of adhering to this rule, therefore, is the ability to avoid this fee—which can result in significant savings depending on the amount withdrawn.
You can potentially reduce your tax liability
The rule of 55 is also advantageous when incorporated into tax-reduction strategies, such as planning to withdraw from a taxable retirement account during a year when your income is lower than amounts anticipated in future years.
Rule of 55 disadvantages
You’ll miss out on investment growth
Some of the most obvious drawbacks to the rule of 55 include the risk of missing out on potential investment growth or depleting your funds too early, leaving you with less for retirement—which is often very expensive.
You may be moved into a higher tax bracket
Other less obvious consequences involve money withdrawn from a 401(k) or 403(b) taxed as regular income (potentially pushing you into a higher tax bracket depending on the amount taken out) and thus negatively impacting an older spouse who receives Medicare or Social Security benefits and files taxes jointly; this can lead to a higher proportion of taxed Social Security benefits and increased Medicare premiums.
You can only access the 401(k) from your current or most recent job
Those who have multiple 401(k) accounts with previous employers cannot access those funds when utilizing this rule, though there is a potential workaround whereby you roll over the money into your current employer’s plan before you leave (provided this is allowed).
Rule of 55 withdrawal alternatives
If you don’t meet rule of 55 eligibility requirements, don’t worry! You have other options at your disposal to take penalty-free distributions from retirement accounts upon hitting age 59½.
Substantially equal periodic payment (SEPP) plans
You can use a substantially equal periodic payment (SEPP) plan allowing you to withdraw funds from qualified employer retirement plans (e.g., an IRA) in equal payments for either five years or until you turn 59½—whichever comes later. While you won’t face early withdrawal penalties in doing so, you’ll still owe income taxes on these withdrawals. Note that you can’t establish a SEPP program for an employer-sponsored 401(k) unless you no longer work for said employer.
401(k) loans
Another option is to borrow from your 401(k), provided your employer allows this (most do). By law, the maximum loan amount you can borrow is generally 50% of your vested account balance or $50,000—whichever is less. As with many other options, 401(k) loans do have some pros and cons.
Hardship distributions—whereby the IRS allows you to withdraw money from your 401(k) if you have an “immediate or heavy financial need” such as medical or educational expenses—is another alternative. Note you can only withdraw the amount necessary to meet this need, funds are taxed, and money cannot be returned to the account. While a hardship withdrawal can provide access to funds, whether or not you avoid the 10% early withdrawal penalty ultimately depends on how you use the money.
In sum: using the rule of 55 for early retirement withdrawals
While the rule of 55 allows 401(k) or 403(b) withdrawals when you leave your job, you’ll generally want to avoid using this provision unless absolutely necessary. Should you find yourself in need of funds and thus considering a retirement account distribution, it's important to consult a financial advisor who can help you evaluate your options and make the best decision for your own unique situation.
Still have questions about your early withdrawal options? Schedule a FREE discovery call with one of our CFP® professionals to get them answered.
FAQs
-
The rule of 55 permits penalty-free early withdrawals but only from the retirement plan associated with your most recent employer, withdrawals from other plans still subject to standard age-based withdrawal rules.
-
The rule applies to the calendar year when a public safety employee turns 50.
-
Any employee of a city, county, or state who provides police protection, firefighting services, or emergency medical services qualifies for the rule of 55. In addition, federal law enforcement officers, customs and border protection officers, firefighters, and air traffic controllers also qualify.
-
No, you must leave your job during the year you turn 55 (or later) to qualify.
-
Yes. If you leave your job for any reason and want to access 401(k) funds per the rule of 55, you must leave your money in the employer's plan—at least until you turn 59½, that is.
-
These contributions are generally considered tax-free when withdrawn early, meaning you may be able to withdraw them in the absence of federal income tax (but will owe taxes on the earnings portion of the account).
———
Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.
Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business. This information is not intended as authoritative guidance or tax advice. You should consult with your tax advisor for guidance on your specific situation.
