The Rule of 55: How you may Access a 401(k) Before 59½ and Potentially Avoid the 10% Penalty
If you are thinking about retiring early, the Rule of 55 is a retirement planning tool that can make a meaningful difference.
In the right circumstances, it can help bridge the gap between early retirement – or even a less-drastic change of gears – and reaching the more familiar milestone of age 59½.
What is the Rule of 55?
Withdrawals from retirement accounts before reaching age 59½ are often subject to a 10% additional tax.
However, if you leave your employer during or after the calendar year in which you turn 55 years old, distributions from that employer’s retirement plan may be exempt from the 10% additional tax. Certain qualified public safety employees in governmental plans may be eligible for a similar exception using age 50 instead of 55.
While the Rule of 55 may help early retirees avoid the additional tax, withdrawals from pre-tax accounts would still be subject to ordinary income tax.
Requirements for the Rule of 55
To understand if you may qualify, focus on three questions:
Did you leave your job in or after the year you turn 55?
Are withdrawals from that employer’s qualified plan?
Does the plan allow for the withdrawal?
If the answer is yes to all three questions, this Rule may provide a unique opportunity to access retirement savings, penalty-free.
Which Accounts Qualify?
The rule may apply to certain workplace retirement plans. For example, many 401(k) and 403(b) plans could be eligible. Plan rules vary, so it would be wise to confirm with your plan administrator.
The Rule of 55 does not apply to Individual Retirement Accounts (IRAs). This includes Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs.
In general, an eligible state or local governmental 457(b) plan isn’t treated as a qualified retirement plan for this purpose, and distributions from it are not subject to the 10% additional tax. Amounts that originated as rollovers from other plan types can have different treatment—confirm with the plan administrator.
Non-governmental 457(b) plans can have different rules and restrictions – confirm details with your plan’s provider.
How the Rule of 55 Can Help
Whether it’s early retirement, leaving the corporate grind, or transitioning to a different stage in life, the Rule of 55 can help bridge the gap to age 59½ , potentially creating a 4½-year window to unlock retirement plan assets without paying a 10% penalty. In practice, eligibility depends on when you separate from service, which plan you’re withdrawing from, and whether your employer’s plan allows partial or periodic distributions.
Early retirement
Some people want to have the option to retire in their mid-to-late 50s. Kids are often grown, the mortgage may be paid off, and years of savings have hopefully compounded into a nice nest egg. Full-time work could be optional. But access to retirement funds may be limited since most accounts penalize withdrawals before age 59½.
Keeping assets in the employer plan to take advantage of the Rule of 55 can help bridge the gap.
Layoff, buyout, or career break
Exits aren’t always planned. An unexpected reorganization, a voluntary buyout package, company acquisition, or a variety of other late-career surprises can happen.
Keeping assets in the employer plan to take advantage of the Rule of 55 can help bridge the gap.
Avoiding the rollover
Rolling an old 401(k) into an IRA is often a reasonable decision. But timing can be important. Assets rolled from an employer plan to an IRA do not qualify for the Rule of 55 exception. Withdrawals before the age of 59½ are likely to be subject to the 10% penalty.
For those wanting to take advantage of the Rule of 55, keep assets in the employer plan.
Coordinating retirement “buckets”
Many families will have assets spread across different types of accounts:
Taxable brokerage accounts
Workplace retirement plans
IRAs
Annuities
Pensions
Most families hope to manage distributions from these different accounts as efficiently as possible, keeping as much of their savings as possible.
The Rule of 55 with workplace plans can be a valuable option when which bucket to draw from first.
Common Rule of 55 Mistakes
Mistake 1: Rolling plan assets into an IRA
The separation-from-service exception to the 10% additional tax does not apply to IRAs. It would be wise to carefully consider the options if you leave an employer in the year you turn 55 or later.
Mistake 2: Leaving the employer too early
Separation from service must be in the year the participant turns 55 or older in order to avoid the 10% penalty.
Mistake 3: Having multiple plans from multiple employers
The Rule of 55 exception only applies to the workplace plan associated with the employer you separated from at the qualifying time. It does not apply to old plans from previous employers.
Tip: it may make sense to consolidate old plans into their current employer’s plan before retiring, potentially giving yourself penalty-free access in early retirement. Consolidation isn’t always available and could have downsides – poor investment options, plan fees, etc. Consider the pros and cons before moving assets.
Mistake 4: Assuming penalty-free = tax-free
Withdrawals of pre-tax retirement plan assets are typically subject to ordinary income tax. The Rule of 55 only impacts the additional 10% additional tax for distributions prior to the age of 59½.
Bottom Line
The Rule of 55 can be a powerful retirement income planning tool for those in the right circumstances.
Important note: This is general information and not individualized investment, tax, or legal advice. Divvi Wealth Management does not provide tax or legal advice. Consult your tax professional and review your plan’s distribution rules before taking action.
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