The Rule of 55 is a provision that allows penalty-free withdrawals from an employer retirement plan if you leave a job during or after the calendar year you turn 55. The Rule of 55 provides flexibility, whether or not it’s your choice to retire. However, it only sometimes makes sense. There are many variables to consider, especially if you have other resources.
What Is the Rule of 55?
Under the Rule of 55, the IRS permits you to withdraw money from your current 401(k) or 403(b) plan before age 59½ without paying a 10% penalty, as long as you adhere to the following rules.
- You have left your employer, regardless of how your employment ended – quit, retire, laid off, or fired at age 55+.
- Withdrawals occur in the calendar year you turn 55 or later. For instance, you can’t retire at age 53 and start taking 401(k) withdrawals at age 55.
- Withdrawals under the Rule of 55 must be from the retirement plan of the employer you are separated from at age 55+. You can only withdraw under the Rule of 55 from an old 401(k) or 403(b) if it was rolled into your current 401k.
There are a few other important points to be aware of
- For some public service employees, applying the Rule in the calendar year you turn 50 is possible. Firefighters, police officers, EMTs, air traffic controllers, or other public safety occupations with a 403(b) could begin withdrawing five years earlier, depending on their situation.
- Even though you can withdraw money penalty-free, you will still need to pay income taxes on the pre-tax amounts withdrawn.
- Roth 401k distributions are allowable and still considered tax-free.
- The Rule of 55 does not apply to individual retirement accounts (IRAs).
- You aren’t locked into retirement. Suppose you decide to return to work part-time or full-time. In that case, you can keep taking withdrawals without penalty as long as they only come from the retirement account you began withdrawing from.
- You aren’t locked into withdrawals. The Rule of 55 does not impose limits or minimums to the amount that can be withdrawn. You can start or stop distributions whenever you like.
The rules are precise, so you must follow them before taking money from your retirement account. Otherwise, the IRS will assess a 10% penalty on what you withdraw. That includes the earnings portion of any Roth 401k/403b distributions.
One big note of caution. Employers are not required to allow for the Rule of 55. Even if they do, they may have rules surrounding withdrawal methods, such as requiring you to withdraw all of your money in one lump sum or sign up for a distribution schedule that is not flexible. In our experience, this is the number one pain point with individuals retiring and attempting the Rule of 55.
It costs employers to provide retirement flexibility, and unfortunately, since you’re retired, they no longer care about you. Please check with your retirement plan provider to determine the feasibility of the Rule of 55.
Another way to avoid the Withdrawal Penalty
The Rule of 55 is not the only way to retire early and avoid the 10% early withdrawal penalty. The other option is Rule 72t. You could use this strategy to take substantially equal periodic payments, although it has less flexibility. You must commit to taking those withdrawals for at least five years or until age 59 ½, whichever is longer. Rule 72t can even be used with an IRA. So, if your employer is giving you a hard time about the Rule of 55, you can roll the account into an IRA and implement Rule 72t. Click here to learn more about the 72t.
Should You Use the Rule of 55?
The Rule of 55 could be helpful if the following circumstances apply:
Income-replacement: If you don’t have any other resources or choices when you either want to retire early or have to retire early, even temporarily. Then, the Rule of 55 could be an income-replacement strategy and a financial lifesaver.
Tax-planning opportunities: Consider the tax-planning opportunities the Rule of 55 could offer if you’re in a low-income tax bracket. The Rule of 55 withdrawals allows you to maximize lower federal tax brackets in your fifties while reducing the size of your required minimum distributions (RMDs) from tax-deferred qualified retirement accounts beginning at age 73.
There is a possibility that your income tax rate in your seventies is higher than it will be in your fifties due to substantial RMDs. The Rule of 55 could help you have more control over your taxable income later in retirement.
Who Shouldn’t Use the Rule of 55
Just because you can use the Rule of 55 doesn’t mean you should. There can be significant drawbacks.
Reducing your retirement savings prematurely, especially if you don’t need to. When you withdraw at 55, you forfeit all the potential growth. Those in their 50s may have a long retirement ahead of them, and withdrawing from a retirement account at a young age could cause it to deplete more quickly, putting your retirement at risk. If you’re afraid you’ll run out of retirement funds, consider other options.
The amount you withdraw from a tax-deferred 401(k) or 403(b) will be taxed as regular income. This could have unintended consequences, such as moving you into a higher tax bracket or losing the Premium Tax Credit. The Premium Tax Credit is a refundable tax credit that can lower your insurance premium costs when you enroll in a health plan through the Health Insurance Marketplace.
If you have other resources you could tap into, it may not be the best course to withdraw from your retirement accounts. One of the best other sources is an investment account. A plain, not exciting, investment account can help you bridge the gap until age 59 1/2. No withdrawal restrictions and no income taxes, although it is subject to tax on capital gains, interest, and dividends. The taxable account is another tool in the retirement income toolbox. Click here to learn more about how a taxable investment account can help you retire early.
The bottom line
The Rule of 55 does provide the opportunity to retire early, on your terms, or help replace income when not on your terms. It takes detailed retirement and income tax planning to determine if the Rule of 55 suits you and just enough variables to make the decision difficult. Give us a call to help you figure out your withdrawal strategy.
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