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What Is the Rule of 55, and How Does It Work?

Here's how the 401k 55 rule works.
Here's how the 401k 55 rule works.

Employer-sponsored, tax-deferred retirement plans like 401(k)s and 403(b)s have rules about when you can access your funds. As a general rule, if you withdraw funds before age 59 ½, you’ll trigger an IRS tax penalty of 10%. The good news is that there’s a way to take your distributions a few years early without incurring this penalty. This is known as the Rule of 55. If you’re contemplating early retirement or need to take money from your 401(k) or a similar plan for any other reason, it’s helpful to know how the rule of 55 works.

What Is the Rule of 55?

Under the terms of this rule, you can withdraw funds from your current job’s 401(k) or 403(b) plan with no 10% tax penalty if you leave that job in or after the year you turn 55. (Qualified public safety workers can start even earlier, at 50.) It doesn’t matter whether you were laid off, fired, or just quit.

The distributions are not completely tax free: Like all withdrawals from a traditional 401(k) or 403(b), you do have to pay income tax. (The employer is required to withhold 20% from any Rule of 55 withdrawal for federal income tax, which is non-negotiable.) Only the 10% tax penalty is bypassed in this scenario.

In addition, note that employers are not obliged to allow early withdrawals; and, if they do allow them, they may require that the entire amount be taken out in one lump-sum withdrawal. This could expose you to a higher income tax.

This rule applies to current – not former – 401(k) or 403(b) plans. The government does not permit penalty-free withdrawals before 59 ½ from plans you had with a previous employer. If you want access to that money under the Rule of 55, you would have to transfer those funds into your current 401(k) or 403(b) plan.

Timing is Critical

Here's how the 401k 55 rule works.
Here's how the 401k 55 rule works.

The timing of your early withdrawals is important, says Dave Lowell, certified financial planner and founder of Up Your Money Game.

“If you were employed for most of the year and had a relatively high income, then it makes sense to not withdraw money under the Rule of 55 in that calendar year, since it will add to your total income for the year and possibly result in you moving to a higher marginal tax bracket,” Lowell says.

The better strategy in that scenario may be to use other savings or take withdrawals from after-tax investments until the next calendar rolls around. This may result in your taxable income being much lower.

Alternatives to Rule of 55 Withdrawals

The Rule of 55, which doesn’t apply to traditional or Roth IRAs, isn’t the only way to get money from your retirement plan early. For example, you won’t pay the penalty if distributions are taken early because:

  • You become totally and permanently disabled.

  • You pass away and your beneficiary or estate is withdrawing money from the plan.

  • You’re taking distributions to pay deductible medical expenses that exceed 7.5% of your adjusted gross income.

  • Distributions are taken as the result of an IRS levy.

  • You’re receiving qualified reservist distributions.

You can also avoid the 10% early withdrawal penalty if early distributions are made as part of a series of substantially equal periodic payments, known as a SEPP plan. You have to be separated from service to qualify for this exception if you’re taking money from an employer’s plan, but you’re not subject to the 55 or older requirement. The payment amounts you’d receive would be based on your life expectancy.

Bottom Line

The rule of 55 allows you to take money from your employer’s retirement plan without a tax penalty before age 59 1/2, but that doesn’t necessarily mean you should. Whether an early retirement is right for you depends largely on your goals and overall financial situation.

“Retiring earlier than 62 means no Social Security income,” Lowell says. “The person needs to make sure they know where their income is coming from.”

For example, will you have a pension that pays out regular annuity payments to rely on? Or will you be able to draw from taxable investment accounts, savings accounts, CDs or other assets to cover your expenses in early retirement?

If you plan to retire early but you don’t think you’ll need to tap into your 401(k) just yet, consider what else you could do with it. Leaving it with your employer to continue growing is one option; rolling it over to an IRA is another. The more thought you give to how and when you’ll need to use those assets beforehand, the better you can position yourself for a financially sound early retirement.

Tips for Retirement Planning

Here's how the 401k 55 rule works.
Here's how the 401k 55 rule works.
  • Check with your employer’s plan administrator to see if they allow a Rule of 55 withdrawal and, if so, whether the money must come out in one single payment or not.

  • If you’re considering leaving the workforce ahead of your normal retirement age, take time to understand what means for your retirement income plan. Use a retirement calculator to estimate how much you’ll need to retire. A 401(k) calculator can give you an idea of how much you’ll be able to grow your savings in your employer’s plan ahead of your target retirement date.

  • Meet with your financial advisor to discuss the pros and cons of retiring early. Don’t have a financial advisor? Finding an advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

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