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How to make Penalty-free Withdrawals: The Rule of 55
March 29, 2022
The Internal Revenue Service (IRS) makes early withdrawals from tax-advantaged retirement accounts difficult: officials want account holders to maintain money in the accounts for long-term support. This is due to the fact that retirement accounts exist to aid you in investing in order to establish money for your retirement years.
Your 401(k) account is likely one of your most vital assets, so understanding when and how to use it is paramount. As these funds are meant to support your retirement, you can use them penalty-free when you reach the age of 59 ½. However, not everyone can wait until that age to begin taking withdrawals from their retirement funds. Taking money out of your 401(k) before then will generally cost you a lot of money: early withdrawals are subject to a 10% penalty.
If you’ve ever invested in a 401(k), 403(b), or other tax-deferred plan, you’re probably aware about this policy and thinking “Can I make an early withdrawal from my 401(k) without penalty?” Fortunately, tax-favored retirement plans provide a lesser-known alternative for penalty-free early withdrawals: the rule of 55.
What is the Rule of 55?
The rule of 55 is an IRS regulation that permits you to avoid paying the 10% early withdrawal penalty on 401(k) and 403(b) retirement funds if you quit your employment during or after the calendar year in which you reach the age of 55.The regulation applies autonomously of the terms of your separation, so it doesn’t matter if you were laid off, fired, or opted to retire early to take advantage of it – only the timing does.
To get a penalty-free distribution, you must quit your employment in the calendar year you turn 55 or later, per the IRS rules. Depending on the circumstances, this regulation applies to some public safety professionals, such as firemen, air traffic controllers, and police officers, at the age of 50.
When does the rule not apply?
If you’re deliberately aiming to retire early, there is a way around this. Before you depart, you could transfer funds from your previous 401(k) and IRA plans into your current 401(k). You may use the rule of 55 to gain access to the money in this manner. It should be emphasized that the procedure can be complex, and not all companies accept rollovers. To reduce potential inconveniences, communicate with your human resources representative and a tax adviser before executing a transfer.
- Individual Retirement Accounts (IRAs), including conventional, Roth, and rollover accounts, are not covered by this exemption.
- Not all companies will allow early withdrawals, and even if they do, you may be obliged to withdraw all of your money in one lump amount. To learn more about your retirement plan's policies, consult your plan's provider.
- Under the rule of 55, penalty-free early withdrawals are only permissible for funds invested in your most recent company's 401(k) or 403(b).
If you’re deliberately aiming to retire early, there is a way around this. Before you depart, you could transfer funds from your previous 401(k) and IRA plans into your current 401(k). You may use the rule of 55 to gain access to the money in this manner.It should be emphasized that the procedure can be complex, and not all companies accept rollovers. To reduce potential inconveniences, communicate with your human resources representative and a tax adviser before executing a transfer.
Can you still withdraw early, even if you get a new job?
If you opt to take early withdrawals at age 55, you are not tied into early retirement. If you decide to return to part-time or even full-time employment, you can continue to take withdrawals without incurring the 401(k) penalty—as long as they are exclusively from the retirement account from which you began withdrawing.
Should I use the Rule of 55?
You shouldn’t take early distributions from your 401(k) or 403(b) just because you can. Depending on your financial circumstances, it may be preferable to let your money grow. However, if any of the following conditions occur, you might consider using the rule of 55:
- You aim for an early retirement. You'll be able to access the money you need to pay costs thanks to the rule of 55, and if you decide to acquire a job later, you may still take withdrawals from your qualified 401(k) or 403(b) as needed.
- You want to reduce or eliminate RMDs. When you reach the age of 72, you must begin taking required minimum distributions (RMDs) from most eligible retirement accounts. Depending on your circumstances, it may make sense to apply the rule of 55 to cut down on the amount included in your RMD calculations. It's worth noting that any funds you don't withdraw now may inflate into a big RMD issue later on, over which you have no influence over tax rates. It is essential to seek the advice of a retirement professional to assist you with such drawdowns.
The Bottom Line
In some instances, taking advantage of the Rule of 55 and withdrawing money from your 401(k) or 403(b) before the age of 59 ½ may make sense. However, it is typically suggested that you leave your money in your retirement accounts to grow for as long as possible
Taxes, life expectancy, savings and investment accounts, and other variables should all be considered before withdrawing from your 401(k) early. If you’re considering about using the Rule of 55, speak to a financial planner to determine if it’s the right approach for you.
Disclaimer
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