If you’re thinking about early retirement, the Rule of 55 may be the most useful IRS provision you’ve never heard of.
This rule allows you to withdraw from your 401(k) penalty-free if you are laid off, fired or resign from your job starting in the year you turn 55. That’s nearly five years earlier than the standard 59½ threshold.
“The Rule of 55 is a cool rule if you can swing it,” says Wes Moss, a fiduciary financial advisor with Capital Investment Advisors who answers reader questions in our Ask an Advisor series. Wes considers it one of the most underused tools for people who want to retire sooner, and his research supports making the leap earlier when the numbers allow it: “My research consistently shows a significant jump in happiness and overall well-being for those who transition from working to retirement.”
In this article, we’ll explain how the Rule of 55 works, its fine print, and whether it’s a good idea for you to use it.
What Is the Rule of 55?
Normally, if you withdraw from a 401(k) or IRA before turning 59½, you’ll owe the IRS a 10% early withdrawal tax penalty on top of regular income taxes.
There are several exceptions to the 59½ withdrawal age. Perhaps the most notable is the Rule of 55.
If you leave your job during or after the calendar year you turn 55, you’re eligible to take early withdrawals from that job’s 401(k) plan without the penalty. Note the phrasing: the calendar year you turn 55. If your birthday is in November and you leave your job in March of that same year at age 54, you still qualify.
It doesn’t matter how you leave. You can quit, get laid off or take a buyout, and you’re still eligible.
So why isn’t the rule more widely used? Wes says it comes with layers of fine print that trip people up. “Think of it as financial tiramisu,” he says. “Delicious, but with distinct layers.”
Limitations of the Rule of 55
Here are those layers. The Rule of 55:
Applies to 401(k) plans (and many 403(b) plans). IRAs aren’t eligible for early withdrawals via the Rule of 55.
Works only with the retirement plan at your most recent job. If you have other 401(k)s from previous employers, you won’t be able to withdraw from them penalty-free under the Rule of 55. You’ll need to wait until you’re 59½.
Doesn’t obligate employers to offer early distributions. Your 401(k) plan can allow early withdrawals under the Rule of 55, but it doesn’t have to. The good news: Moss cites research indicating that roughly 85% of plans permit it. But your company can decide to pay you only via a one-time lump sum if you want to withdraw early, which can lead to negative tax and investment consequences. Check with your plan administrator.
Disappears if you roll your money into an IRA. This mistake is permanent. The moment you roll your 401(k) into an IRA, the Rule of 55 no longer applies to that money and you’re back to waiting until 59½. Plenty of people leave a job, follow the standard advice to roll everything over, and unknowingly lock the door on penalty-free access.
Doesn’t excuse you from paying income taxes on your 401(k) withdrawals. The Rule of 55 exempts you from the 10% early withdrawal penalty. But any money you take out of a traditional account counts as ordinary income you’ll need to report when you do your taxes.
Includes mandatory withholding for taxes. Many lump-sum distributions from employer retirement plans are subject to mandatory 20% federal tax withholding, even if your eventual tax bill is lower. Your actual tax liability may differ, and you could receive a refund or owe additional taxes when you file your return.
Rule of 55 Can Be Rule of 50 for Public Safety Employees
If you’re a public safety employee and you meet certain criteria, you may be able to withdraw 401(k) funds penalty-free starting the year you turn 50.
Public safety employees include:
Firefighters
Police officers
Emergency Medical Technicians (EMTs)
Correctional officers
Air traffic controllers
How To Use the Rule of 55 To Fund Your Early Retirement
If you’re interested in making penalty-free withdrawals between the ages of 55 and 59½, make sure you’ve thought through the implications and potential snags.
Here are a few things to consider before you put this plan into motion:
Make sure your employer supports early withdrawals. Companies don’t have to allow early withdrawals under the Rule of 55, and some only allow lump-sum withdrawals. Confirm both before you build a retirement date around this rule.
Consider rolling any old 401(k) funds into your current 401(k) before you leave. Until you turn 59½, you can withdraw penalty-free only from the 401(k) at your most recent job. Consolidating first puts all that money under the rule. Not all employers accept rollover contributions, especially from retirement plans that aren’t workplace-related.
Wait at least until the year you turn 55 to leave your job. If you leave or lose your job in the year of your 54th birthday, you aren’t eligible for Rule of 55 withdrawals.
Consider waiting until January the year after you retire to withdraw. Taking money out of your 401(k) adds to your taxable income. So if you retire mid-year, you may want to wait until the start of the next calendar year to withdraw. That way, you’re not stacking withdrawals on top of a year’s salary.
You can return to work while continuing to withdraw penalty-free. Once you start using the Rule of 55 to take money out of your most recent 401(k), you’re allowed to start working again, part-time or full-time. You can still withdraw without paying a penalty, but only from the same 401(k) you’ve been tapping for income.
Should You Take Advantage of the Rule of 55?
As the saying goes, just because you can do something doesn’t mean you should.
It’s generally a good idea to leave your retirement account alone as long as possible. Withdrawing your 401(k) money early can sink your future retirement income, especially if the stock market has a couple of down years while you’re taking early withdrawals.
If you retire early, one option is to find freelance or part-time work to bridge the gap before you can start taking Social Security benefits at age 62. That way, your 401(k) investments have more time to grow. (Money expert Clark Howard recommends you wait to take Social Security benefits as long as you can.)
That said, Wes pushes back on the idea that later is always better. His research on retiree happiness points the other way for people who have saved enough: The transition out of work tends to come with a measurable improvement in quality of life, and the Rule of 55 is one of the few tools that makes that transition possible before 59½ without a penalty.
There are a couple of situations where using the rule makes sense:
You’re in a safe position to retire early. If you’re considering retiring early and using the Rule of 55 for income, make sure it’s financially prudent for you. Consider talking to a financial advisor first.
You’re being strategic about your taxes. Withdrawing from a taxable retirement plan during a low-income year could save you some tax money. This is especially true if your taxes may be higher in the future when you plan to take withdrawals.
More Information on Rule of 55 Tax Strategy
It’s a good idea to talk to a financial advisor or a Certified Public Accountant (CPA) specializing in taxes before implementing an early retirement plan.
There are other potential tax reasons to be strategic with early withdrawals.
The IRS says you must take Required Minimum Distributions (RMDs) from your 401(k) starting at 73 years old. The more money that remains in your 401(k), the higher your RMDs will be each year. That could push you into a higher tax bracket.
It may be better to roll some of your 401(k) into a Roth IRA than to take early withdrawals from your 401(k).
You’ll owe immediate taxes on the money you take out of your traditional 401(k), just as you will on any funds you roll into a Roth IRA. Money converted from a traditional 401(k) to a Roth IRA is generally subject to a separate five-year holding period before converted amounts can be withdrawn penalty-free if you’re under age 59½.
IRS Publication 575 provides more guidance on the Rule of 55.
The tax implications of retirement accounts can get complicated quickly, so don’t hesitate to seek professional advice.
Other 401(k) Early Withdrawal Exceptions
Several other circumstances will allow you (or your beneficiary) to withdraw from your 401(k) account before you reach 59½ without paying a 10% penalty.
Some of those include:
The Rule of 72(t). This lets you take penalty-free withdrawals from an IRA or 401(k) at any age through Substantially Equal Periodic Payments. It’s the main option if you’re under 55 or your savings are in IRAs, but it locks you into a payment schedule and requires professional guidance to set up.
Total, permanent disability
Death
Medical expenses that exceed 10% of your Adjusted Gross Income (AGI)
IRS levy
Qualified disasters
Qualified military reservists who are called to active duty
Final Thoughts
The Rule of 55 won’t make an early retirement affordable if you haven’t saved enough. But if you’re already financially prepared, it can give you more flexibility over when you retire by allowing penalty-free access to your current employer’s 401(k) years earlier.
Before you base your retirement plans on this strategy, confirm that your employer’s retirement plan allows Rule of 55 distributions and think through the tax implications of taking withdrawals. If you’re unsure, a financial advisor or tax professional can help you determine whether this approach fits your overall retirement plan.
For many people, leaving retirement savings untouched as long as possible is still the smartest move. But if you’ve done the hard work of building a strong nest egg, the Rule of 55 may be one of the most valuable tools for making an earlier retirement possible.
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