Using the Rule of 55 to Take Early 401(k) Withdraws

While we generally don’t advise taking early distributions (withdrawals) from your retirement accounts, exceptions do in fact exist. For example, perhaps you’re retiring early and need to access your retirement funds or find yourself in a challenging predicament due to a job loss or health-related issue. Regardless of your circumstances, you should familiarize yourself with the rule of 55 to help avoid IRS fees if you require early access to your employer-sponsored retirement account such as a 401(k) or 403(b).

What is the rule of 55?

The rule of 55 is an IRS provision that allows workers who leave a job to withdraw funds from an employer-sponsored retirement account penalty-free (while still paying income taxes). The rule dictates that beneficiaries must fall between the ages of 55 and 59.5 and can only access funds from a 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. The circumstances surrounding this newfound unemployment—whether the employee quit or was fired/laid off—are irrelevant with respect to this provision.

Rule of 55 advantages

Making a withdrawal prior to age 59.5 typically subjects you to a 10% early withdrawal penalty from the IRS. Therefore, the biggest advantage of the rule is avoiding this penalty—which can ultimately save you a lot of dough, depending on your distribution amount.

The rule of 55 is also beneficial when mixed into tax-reduction strategies (e.g., you can plan to withdraw from a taxable retirement plan during a year when you bring in less income than what you foresee in subsequent years).

Rule of 55 disadvantages

Some of the most obvious rule of 55 drawbacks include missing out on potential growth—depending on your investment performance—and early fund access driving early depletion, leaving less for retirement (and remember, retirement is certainly not cheap).

Some less obvious consequences are also associated with this rule. For example, the money you withdraw from your 401(k) or 403(b) will be taxed as regular income, perhaps triggering other issues (e.g., depending on the amount you withdraw, you could end up in a higher tax bracket and thus owe more to Uncle Sam). A higher income can also adversely impact you if an older spouse receives Medicare or Social Security benefits and files jointly; more specifically, he/she can see a higher proportion of SS benefits taxed as well as increased Medicare premiums.

If you have multiple 401(k) accounts with previous employers, know that you cannot use those funds when taking advantage of this rule. There is a potential workaround, however, as you can roll the money into your current employer’s plan before you leave (if allowed).

Utilizing the rule of 55

Before taking advantage of this provision, you’ll need to ensure your employer allows early withdrawals—as not all do. If you’re in the clear, take time to learn all associated rules as some companies require the entire amount to be taken out as a lump sum withdrawal while others dictate you establish a distribution schedule. As either scenario can propel you into a higher income tax bracket, you’ll want to carefully consider the timing of your distribution (e.g., waiting to take an early withdrawal at the start of a new tax year) and/or whether this option is even worth pursuing at all.

Other rule of 55 considerations

If you use the rule of 55 to withdraw money from a Roth 401(k), you’ll only owe taxes on your earnings—not your distributions.

If you’ve already begun taking distributions from your most recent employer’s 401(k) or 403(b), the rule allows you to return to work for a new company. In fact, you can continue tapping into the same 401(k) for distributions while simultaneously participating in your new employer’s retirement plan!

Rule of 55 alternatives

If you don’t meet eligibility requirements for the rule of 55, fret not: there are other ways to take penalty-free distributions from your retirement accounts before the age of 59.5.

One such alternative? You can rely on a substantially equal periodic payment (SEPP) plan, which allows you to distribute funds from qualified retirement plans including IRAs; funds are withdrawn in equal payments for five years or until you turn 59.5 years old (whichever comes later), and while you’re not subject to early withdrawal penalties, you’d still incur income taxes on these withdrawals.

Borrowing from your 401(k) is another option, assuming 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.

With hardship distributions, meanwhile, the IRS allows you to withdraw money from your 401(k) if you have an “immediate or heavy financial need” such as medical or education expenses. You can only use the amount withdrawn to satisfy said financial need, with the money taxed and unable to return to your account. While a hardship withdrawal does give you access to these funds, whether or not you’ll skirt the 10% early withdrawal penalty largely depends on how you ultimately use these funds.

In sum: the rule of 55

While the rule of 55 means you can easily withdraw money from your 401(k) or 403(b) upon leaving your job, you’ll want to avoid taking advantage of this provision. If you find yourself in need of money and pondering a retirement account distribution, however, be sure to speak to a financial advisor so he or she can help evaluate your options and make the best decision for your needs, accordingly.

Still have questions about your early withdrawal options? Schedule a FREE Discovery call with one of our CFP® professionals.

FAQs

• Can I withdraw from multiple retirement plans using the rule of 55?

  The rule of 55 allows penalty-free early withdrawals but only from the retirement plan associated with your most recent employer; withdrawals from other retirement plans are subject to standard age-based withdrawal rules.

• What is the time period of this rule for public safety employees?

  The rule applies for the calendar year in which public safety employees turn 50.

• Which public safety employees qualify for early retirement fund access?

  Public safety employees such as police officers, firefighters, EMTs, and air traffic controllers are eligible for this rule.

• Does the rule of 55 apply if I leave my job at, say, age 53?

  No; you must leave your job during the calendar year you turn 55+ to qualify.

• Am I required to leave the balance in my employer's 401(k) while taking early withdrawals?

  If you leave your job for any reason and want access to 401(k) funds per the rule of 55, you must leave your money in the employer's plan—at least until you turn 59.5, that is.

• Are Roth contributions to a 401(k) tax-free when withdrawn early?

  Roth contributions to a 401(k) are generally considered tax-free when withdrawn early, meaning you may be able to withdraw these in the absence of federal income tax; carefully assess the situation and consider related factors before making a decision, however.

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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.