The goal of saving for retirement means just what it says: you’re saving the money that you’ll need to live on once you retire. Many people save their money through their employers’ 401(k) program.
Because that money is supposed to be used later in your life, which is typically when people retire, there is a 10% penalty imposed on you if you withdraw it prior to age 59 1/2. However, if you need it, there is a way to start accessing that money penalty-free a few years earlier. That’s where the Rule of 55 comes into play.
The Rule of 55 is an exception to the age when people can withdraw money from their 401(k)s. Using the Rule of 55, you are allowed to withdraw that money starting during the calendar year when you turn 55 if you are laid off of your job, fired from it, or you quit it during that year. In those cases, no penalty is charged for the withdrawal of funds from your current 401(k).Sounds too good to be true, right? Well, it is and it isn’t. Here’s all you need to know about the Rule of 55 and whether you should take advantage of it or not.
Table Of contents
- What Is The Rule Of 55
- Which Retirement Accounts Apply And Which Don’t
- Pros And Cons To Withdrawing Early
- An Alternative Way To Withdraw Money Early
- Bottom Line
What Is The Rule of 55
As we mentioned, under normal circumstances, you are not allowed to withdraw any money from your 401(k) prior to turning 59 1/2 without incurring a 10% penalty. However, the Rule of 55 allows you to withdraw that money penalty-free if you are laid off, fired, or quit your job during the calendar year that you turn 55.
You can take advantage of the Rule of 55 any time from when you’re 55 through 59 1/2 as long as you leave in some way the job that you had when you’re 55. After you turn 59 1/2, you can access the money at any time penalty-free whether you are employed or not.
Note: Public safety workers (firefighter, police office, air traffic controller, etc.) actually have the Rule of 50. That means they can access your 401(k) money penalty-free when they’re 50 as long as they leave their job or lose it in the calendar year that they turn 50.
Listen: The Rule Of 55
Which Retirement Accounts Apply And Which Do Not
The Rule of 55 only applies to money that you have in your 401(k) or 403(b) accounts. You cannot use it to access money in your IRA or any other account you might have.
It also only applies to assets that you have in the 401(k) or 403(b) that you have with your current employer, the one that you’re leaving when you’re 55. If you have funds in another retirement account through a previous employer, you are not allowed to touch those until you’re 59 1/2. If you do, you’ll be subject to the 10% penalty.
There is one way around this. If you roll over all of your accounts into your 401(k) or 403(b) accounts that you have with your current employer prior to leaving that job, you can access all of the funds through the Rule of 55 with no penalty.
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Pros And cons to withdrawing early
Accessing your 401(k) money prior to the established withdrawal date using the Rule of 55 has both pros and cons.
Pros To Withdrawing Under The Rule Of 55
Being able to withdraw the money penalty-free is a definite safety net. If you unexpectedly lose a job or decide to quit when you’re 55, it’s good to know you can access your money. You could use it as a secondary emergency fund that you hope you don’t have to access but know that you can. However, this would be a last resort emergency fund. You shouldn’t touch this one unless all other options for obtaining the money you need are exhausted.
The Rule of 55 doesn’t set limits or restrictions on how much money you take from your account. So you don’t have to use the whole thing and are allowed to only take what you need. Once you access your money using the Rule of 55, you can also make as many withdrawals from the account that you want.
Finally, we want to highlight again that any withdrawal you make under the Rule of 55 is penalty free. If you withdraw the money prior to turning 59 1/2 not using the Rule of 55, you’ll have to pay a penalty of 10%.
Cons To Withdrawing Under The Rule Of 55
If you expect to live a long life, this could hurt your future income by leaving you short on funds for the later years of your life. For that reason, you should only withdraw your funds after careful consideration of all of your retirement accounts. Make sure that you have enough to last you minus the money you’re taking out of your 401(k) or 403(b) under the Rule of 55.
Just because you don’t pay a penalty for early withdrawal under the Rule of 55 doesn’t mean that you don’t have to pay in other ways.
The money you take out will still be considered income and therefore subject to taxes. You should consult your tax accountant prior to withdrawing via the Rule of 55. See if they recommend a prime time to withdraw the money and pay the least amount of taxes on it.
There is the possibility that retrieving funds could de-value your portfolio in the long-term. This also relates back to taxes and, again, we recommend that you speak to a tax professional prior to withdrawing so that you can minimize the future impact on your portfolio.
Listen: Sequence Of Return Risk | Early Retirement Now
An Alternative Way To Withdraw Money Early
If you don’t want to use the Rule of 55, you can use something called a Section 72(t) distribution. It’s a complicated withdrawal process that uses your anticipated life expectancy to determine five substantially equal periodic payments (SEPPs). You must take the payments either over five years or before you turn 59 1/2, whichever time frame is longer. You can read more on Investopedia about how the payments are calculated.
Because of tax implications, you should take the same precautions using the Section 72(t) distribution as you do when withdrawing using the Rule of 55.
Bottom line
If you need to use the Rule of 55, do so with caution. Consider the long-term effects on your portfolio and some potential tax implications. We recommend that you exhaust all other options prior to taking out the money using this method. That includes searching for a new job.
If you do have to use it, utilize the Rule of 55 and save yourself as much money in fees and taxes as possible.
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