People who are looking for information on how to retire early often perk up when they hear about the “Rule of 55,” an exception that allows some people to withdraw retirement funds early without paying a tax penalty. The rule itself is fairly simple, but its repercussions can be significant, warns retirement wealth specialist Nicholas Bunio, CFP.
Here’s what you should know about the Rule of 55 and how to proceed without derailing your retirement…
This IRS rule applies only to employer-sponsored plans such as 401(k)s and 403(b)s. Outside of the rule, you must be age 591/2 or older to withdraw funds from those types of accounts without paying a 10% penalty.
Under the Rule of 55, 401(k) and 403(b) account holders may begin withdrawing without paying the penalty if they lose or quit their jobs at the age of 55 or older. (For people in certain public-safety occupations, they can actually start withdrawing by age 50.) Of course, you’ll still pay taxes on your withdrawals, but the 10% penalty is waived.
The rules for eligibility include several details that can present pitfalls for people considering taking advantage of the Rule of 55.
Timing: You must either be above age 55 or turn 55 in the same calendar year in which you separate from your job.
Pitfall: You aren’t eligible if you lose or quit your job when you’re, say, 53 and then wait two years to begin making withdrawals. But to be clear, although it’s called the Rule of 55, it’s fine if your separation occurs when you’re 56, 57, 58 and so on.
Specific account: There’s only one account for which you’re eligible to take advantage of this rule, and that’s the account sponsored by the company by which you were employed at the time you stopped working.
Pitfall: If you worked for other employers throughout your career and have other 401(k) or 403(b) accounts out there, the rule doesn’t apply to them. But you can roll the funds from those other accounts into your current one to make them eligible for penalty-free withdrawal before leaving your job.
Account type: The rule applies only to 401(k)s, 403(b)s and Thrift Savings Plans (TSPs). It does not apply to retirement accounts such as IRAs (including SEP and SIMPLE IRAs). For 457 accounts, the Rule of 55 only incidentally applies—those types of accounts let you withdraw money and without a penalty if you leave or are let go from the company that sponsored it. But the 457-holder need not be 55. Rather, they can be any age at all.
Pitfall: If you plan to take advantage of this rule, don’t make the mistake of rolling your 401(k) into an IRA or any other account.
Vesting: If you’re not fully vested in your 401(k) at the time of separation, you may not be able to withdraw company-contributed funds penalty-free.
Pitfall: If you leave your job too early, you may lose access to funds because you weren’t fully vested.
Other concerns: Withdrawing funds from your 401(k) early isn’t something to do casually even if you meet the criteria for doing so. Only two categories of people should consider taking advantage of this rule—those with a well-considered plan for retiring early…and those for whom circumstances have made it impossible to keep working.
Retiring early means adding several years to your retirement. Living, say, 10 years longer than you expected can be hard enough financially, but it’s even worse to add those extra 10 years at the front end, because you’re reducing the amount of money in your account and thus its ability to grow.
At age 55, you’re also too young to qualify for Medicare, so you’ll need to have a plan in place to take care of your health-care needs. Similarly, you’ll be too young to draw on Social Security or to tap into any traditional pension plans you have, so unless you work part-time or have other sources of income, you’ll be leaning very heavily on the 401(k) withdrawals.
In a scenario in which an injury or illness prevents you from being able to work, exploiting the Rule of 55 and effectively retiring earlier than you’d planned could prove unavoidable. But you’ll need to give careful thought to rearranging your retirement planning to account for your new circumstances. If there’s any way you can keep working until full retirement age, that’s almost always best.
Another consideration: If your 401(k) dips below $5,000, your employer may insist that you take all of it as a lump sum.
If you’re considering taking advantage of the Rule of 55, talk to a retirement advisor to make sure you’re making the best moves. Example: Is it better to retire in a new calendar year so that you might be in a lower income tax bracket for the year…or to time it so you’re maximizing your deductions for contributing to the plan that year? Every aspect of retirement needs to be evaluated, whether you’re doing it at 55 or 75.
