Most retirement accounts have rules about withdrawals. While you can start investing in accounts like the 401(k) at any point in your career, you can only draw your money after the age of 59.5 years. Withdrawals made before reaching this age are subject to penalties, which can interfere with your overall profits. However, there are some exceptions to this rule. The rule of 55 lets you access your money from the 401(k) and some other accounts without incurring penalties.
A financial advisor can help you understand the rule of 55 for 401(k)s and other retirement accounts and how you can use it. This article will also discuss the details of the rule of 55 and its pros and cons so you can make informed decisions about your 401(k) withdrawals.
What is the rule of 55 for 401(k) accounts and how does it work?
The rule of 55 is a provision introduced by the Internal Revenue Service (IRS) that allows you to make penalty-free withdrawals from your 401(k) or 403(b) accounts if you voluntarily or involuntarily leave your job during or after the calendar year in which you turn 55. Typically, the IRS imposes a 10% early withdrawal penalty for accessing funds from employer-sponsored retirement plans before the age of 59.5 years. However, the rule of 55 is an exception to this regulation and enables you to access your retirement funds earlier. This rule can be particularly beneficial if you are planning for retirement at 55 or if you need additional cash flow before reaching the age of 59.5. It allows you to tap into your retirement savings sooner and provides greater flexibility in managing your finances.
The rule of 55 can only be used under specific circumstances. To take advantage of the rule, two critical conditions must be met. Firstly, the withdrawals must be made the year you turn 55 or later. Secondly, you should not be working with the employer providing the 401(k) at the time of withdrawal. This implies that you must retire, be laid off from your job, or quit your position during or after the calendar year in which you turn 55. You can withdraw funds from your current 401(k) or 403(b) plan without incurring the usual 10% penalty for early withdrawals if these conditions are met. However, if any of these situations occur before the year you turn 55, you will not be eligible for penalty-free withdrawals under this rule.
It is important to note that while your withdrawals are not subjected to the 10% early withdrawal penalty under the rule of 55, all your distributions will still be subject to income tax. Typically, you will pay a 20% tax on the total amount withdrawn. But if this 20% exceeds your actual tax liability for the concerned tax year, you may be eligible for a refund and can apply for the same when you file your annual tax return for the same year.
As the name suggests, the 401(k)-withdrawal age for the rule of 55 is fixed at 55. However, there are some other things to note about this provision, as mentioned below:
a. The IRS offers a special exception to the rule of 55 for some professionals, including Emergency Medical Technicians (EMTs), police officers, firefighters, air traffic controllers, and individuals who hold other public safety positions. In the case of these professionals, the IRS allows penalty-free withdrawals in the calendar year the investor turns 50, instead of 55. In this case, you can gain earlier access to your qualified retirement plans and even consider retiring much earlier.
b. The rule of 55 allows you to withdraw funds from your 401(k) as long as you no longer work with your employer. However, you can find another job later if you wish to. Moreover, if you begin taking penalty-free distributions from your 401(k) and then pick up a job in the future, you do not have to stop your withdrawals and can continue them as before. The same stands true even if you take up a part-time job. Your withdrawals are not affected by your employment status, and you can keep withdrawing funds from the same 401(k) plan without incurring a 10% penalty.
c. An important thing to remember is that if you roll over your 401(k) funds into another retirement plan, such as the Individual Retirement Account (IRA), you will no longer be able to make penalty-free withdrawals under the rule of 55. Rolling these funds over into an IRA will disqualify you from making penalty-free withdrawals under this rule. Additionally, if you have both a 401(k) and an IRA, you will not be able to make penalty-free withdrawals from your IRA unless you meet the account’s withdrawal requirements as set by the IRS. The rule of 55 only applies to 401(k) and 403(b) plans. However, you can withdraw funds from an IRA after the age of 59.5. After this age, all retirement accounts permit penalty-free withdrawals.
d. It is essential to understand that the rule of 55 applies exclusively to the 401(k) or 403(b) from your employer at the time you leave your job. If you leave your job before reaching age 55, you will not be eligible to start penalty-free withdrawals once you turn 55. However, if you leave your job at age 55 or older, you can begin taking penalty-free withdrawals from the 401(k) associated with your former employer.
Before considering the option, it is important to understand its pros and cons to know whether it is the right choice for you.
Below are some pros of the rule of 55:
1. Option to make premature penalty-free withdrawals
The rule of 55 allows you to make withdrawals from your employer-sponsored retirement plans without incurring the 10% early withdrawal penalty. This can help you cater to immediate needs and enjoy more financial liquidity.
2. Suitable if you are looking for early retirement
One of the reasons people often defer early retirement is because they lack access to their retirement accounts before the age of 59.5. Social Security benefits also start from the age of 62 and delaying them until your 70s can further boost the value of your check. However, the rule of 55 helps you retire before the traditional retirement age of 59.5. This can help you in planning for retirement at 55 and accessing your funds early.
3. Ability to change jobs or switch careers
The rule of 55 allows you to make withdrawals as long as you no longer work with the employer offering the plan. However, you can explore new employment avenues with the funds at your disposal after you have quit, retired, or been laid off. You can consider better jobs that align with your interests, start a business, or even take a long sabbatical. With premature withdrawals, you will have enough money to support your financial needs while at the same time, you will also have the financial freedom to pursue newer ventures.
4. Eliminates the need to sell other investments
The rule of 55 is a convenient way to access your savings without disrupting the rest of your investment portfolio. You can access funds from one retirement account while the rest of your portfolio remains untouched. This helps you ensure that your investments get the opportunity to grow and create more wealth for your future retirement needs.
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While the rule of 55 offers several advantages, it is also essential to consider its potential downsides:
1. Puts you in a higher tax bracket
It is important to note that while the distributions are not levied with a penalty, you will owe tax on your funds. The year you make the withdrawals will likely put you in a higher tax bracket. This can drastically increase your overall tax liability. Moreover, some retirement plans only allow participants to make a one-time lump sum withdrawal. In such a case, you may be forced to withdraw all the money from your account, which can lead to an extremely high tax. A higher tax bracket can also inhibit your ability to save and invest for the future.
2. Stops you from earning further gains
If you withdraw your funds prematurely, you lose the potential to earn further gains. While periodic withdrawals still allow the rest of your money to grow over time, some accounts only permit lump sum withdrawals. In such cases, you can no longer earn returns on your investments in the future.
3. Makes it hard to quit your employer before the age of 55
If you wish to use the rule of 55, you will have to stick with the same employer until you turn 55. If you leave your employer before the year you turn 55, you will not be allowed to start penalty-free distributions. In such a scenario, your withdrawals will incur the 10% early withdrawal penalty before age 59.5. If you find a better job, wish to retire early or start a business, you will have to push these goals until you are 55.
4. Adds to the risk of outliving your savings
While the rule of 55 allows you to access your money prematurely, it also adds to the risk of outliving your savings. Withdrawing funds early offers liquidity, but it can lead to depleted savings in the early years of retirement. This can leave you financially dependent in the later years of your retirement. Considering how your healthcare expenses, including long-term care costs, can considerably rise during the later years, it is essential to plan your distributions prudently. A financial advisor can help you create a suitable income and withdrawal strategy that can eliminate longevity risk and ensure all your financial needs are met.
Other questions about the rule of 55
1. Does the rule of 55 apply to pensions?
No, the rule of 55 does not typically apply to pensions. It specifically applies to certain types of employer-sponsored retirement plans, such as 401(k) and 403(b) plans.
2. How much can I withdraw using the rule of 55?
There is no specific limit to the amount you can withdraw from a qualified retirement plan under the rule of 55, provided you meet the qualifying criteria, and your company's plan allows such withdrawals. Some retirement plans permit you to withdraw funds at your discretion, so you can choose the amount and frequency of your withdrawals and enjoy better financial flexibility. Other plans may require you to liquidate your entire account in a single lump sum withdrawal. This can have significant tax implications, as your distribution will be subject to ordinary income tax in the year you take it. So, you must assess your needs carefully and then make a decision about the best way forward.
3. How do I claim the rule of 55?
Here are the steps to claim the rule of 55 and make penalty-free withdrawals from your 401(k) or 403(b) plans:
Step 1: You must ensure that your company offers a qualified retirement plan, such as a 401(k) or 403 (b), that allows for the rule of 55 withdrawals. Not all plans have this provision, so it is essential to confirm this with your employer.
Step 2: You ensure to keep your retirement funds in your employer's 401(k) or 403(b) plan to use the rule of 55. If you wish to take penalty-free withdrawals, you cannot roll these funds into an IRA or another retirement account.
Step 3: You must retire, be laid off, or quit your job during or after the calendar year you turn 55. This can be done either voluntarily or involuntarily.
If you meet these criteria, you can contact your plan administrator and withdraw your funds.
To conclude
The rule of 55 offers several notable benefits for those considering early retirement or needing flexible financial options. It lets you access your money without having to worry about penalties. However, it does come with its limitations, the primary one being tax. Withdrawing funds, especially in a lump sum, can lead to a higher tax output in the year you make withdrawals. Not only does this add to your expenses, but it also interferes with your future goals. Moreover, you lose the chance to earn more returns in the future. Therefore, it is important to keep these factors in mind when deciding on the best course of action. Hiring a financial advisor can also help you make the right decision after understanding the details of the rule of 55 and its pros and cons.
Use the free advisor match tool to get matched with seasoned financial advisors who can help clear all your doubts about the rule of 55 and make careful and prudent decisions about your retirement planning needs. Answer a few simple questions based on your financial needs, and the match tool can help you find 1 to 3 financial advisors who are best suited to help you.