Tax-advantaged retirement accounts aren’t exactly known for their liquidity, and that’s largely thanks to a number of pretty strict rules, with only a few exceptions, governing when you can pull out your funds.
But if you find yourself needing to retire early, you might find one carve-out particularly helpful: The rule of 55.
Listen, there’s no “right” retirement age. Some people choose an early retirement in their 50s and even 40s. Others wait until a few years into their 60s so they can collect Social Security. And still others wait even longer. But you need to understand that sometimes, you don’t pick your retirement age—your life circumstances do the picking for you. It’s not uncommon for Americans to retire earlier than planned because they developed a health issue, need to care for a family member, or got laid off from a job and found it difficult to find another.
The problem? Many people’s retirement plans involve withdrawing money from a 401(k) or equivalent workplace account, such as a 403(b) or Thrift Savings Plan (TSP). And typically, taking a distribution from those accounts before the age of 59½ involves absorbing a 10% early withdrawal penalty—effectively flushing vital retirement funds right down the toilet.
So, what can you do if you retire early but need to access money from your tax-advantaged accounts? Well, if you’re at least age 55 (or, for some workers, even a bit younger), you might be able to take advantage of the Rule of 55 and avoid that hefty penalty. Read on, and I’ll explain how.
What Is the Rule of 55?
As mentioned before, if you begin taking distributions from a workplace retirement plan such as a 401(k), 403(b), or Thrift Savings Plan, you not only will owe taxes on that distribution, but you will also be subject to a 10% penalty.
However, the Rule of 55 allows you to start taking distributions from your 401(k) without the early withdrawal penalty if you have lost or left your job during or after the calendar year in which you turn 55. Taxes will still apply, of course, just like they would if you were age 59½ or older—you’re just dodging the penalty.
It’s worth noting that the Rule of 55 also applies to eligible Roth employer-sponsored accounts, such as a Roth 401(k). With a Roth 401(k), if you withdraw before age 59½ and before you’ve owned that account for five years, you would have to pay taxes on the “earnings” portion of your withdrawal, and the 10% penalty would be applied to that amount. (However, in a Roth account, you can withdraw contributions tax-free, so not only would you not pay taxes on the “contributions” portion of the withdrawal, but the 10% penalty would also not apply.)
How much of your withdrawal would be taxed depends on the ratio of your contributions to earnings in the account. For example: If you had a Roth 401(k) with $5,000 in contributions and $5,000 in earnings, your earnings ratio would be 50%. That means if you took out a $5,000 withdrawal, 50% of that ($2,500) would be taxable. So you’d include $2,500 in the gross annual income you report to the IRS, and you’d be levied an additional 10% penalty on that $2,500. (But the other $2,500 would not be taxed nor penalized.)
Also, the penalty-free withdrawals only apply to the account you were contributing to when you left that job—not every workplace retirement account you own. For example, if you had a 401(k) from your first job 30 years ago, and you had since switched jobs, that account would not be eligible for penalty-free withdrawals until age 59½.
Do you want to get serious about saving and planning for retirement? Sign up for Retire With Riley, Young and the Invested’s free retirement planning newsletter.
Can I Use the Rule of 55 at a Different Age?
You usually must lose or leave your job at age 55 or later for the Rule of 55 to apply. For instance, let’s say you left your job at age 52—you couldn’t start taking 401(k) distributions, even if you waited until age 55, without paying the early withdrawal penalty. You would have to wait until age 59½.
If you lose or leave your job when you’re older than 55, however, then yes, it can still apply. For instance, if you got laid off at age 56, you could immediately begin taking penalty-free withdrawals from that job’s 401(k).
You might have noticed that I said the rule “usually” can’t be applied earlier than age 55. But there is an exception …
The Rule of 55 for Public Safety Employees
Are you a public safety employee of a state or political subdivision of a state? Good news! Qualified public safety employees can start taking penalty-free withdrawals per the rule the calendar year they turn age 50, rather than waiting until age 55.
The IRS also considers qualified public safety employees to include the following:
- Specified federal law enforcement officers
- Corrections officers
- Customs and border protection officers
- Federal firefighters
- Private-sector firefighters
- Air traffic controllers
As usual, always confirm you meet plan requirements before withdrawing money early.
Can I Roll My 401(k) Over to an IRA First?
No. If you roll your 401(k) funds into an individual retirement account (IRA), you no longer have the privilege of avoiding an early withdrawal penalty. The Rule of 55 doesn’t apply to IRAs.
If you want to use the Rule of 55, that balance has to stay in the 401(k) account while you take early withdrawals.
Related: How to Invest for (And in) Retirement: Strategies + Investment Options
What If I Start Working Again?
It’s possible to use the Rule of 55 even if you get another job.
Let’s say you retire at 55 to be a caregiver for an ill family member. Per the Rule of 55, you begin taking penalty-free withdrawals from your most recent employer’s 401(k) plan.
One year later, when you’re 56 years old, your ill family member is placed in a long-term care facility and no longer needs your around-the-clock care. You get a part-time job for some extra income. As long as you were contributing to your 401(k) when you quit and haven’t rolled it over into an IRA or another plan, you may continue taking penalty-free distributions from that 401(k) plan.
Related: 10 Retirement Questions: Are You Ready to Leave the Workforce?
Rule of 55 Withdrawal Alternatives
If you don’t qualify for the Rule of 55 or it doesn’t make sense for you at this time, there are other options for withdrawing money from retirement accounts without paying early withdrawal penalties.
401(k)s
For instance, you don’t have to pay a penalty for early 401(k) withdrawals if any of the following reasons apply:
- You become totally and permanently disabled.
- The distributions are used to pay deductible medical expenses that are over 7.5% of your adjusted gross income.
- Distributions occur because of an IRS levy (legal seizure of property to pay a tax debt).
- You receive qualified reservist distributions.
Additionally, if early distributions are made as part of a series of substantially equal periodic payments (SEPP plan), you can skip the 10% early withdrawal penalty.
IRAs
If you have a Roth IRA, you can withdraw the contributions at any time without penalty or tax because those contributions were made with after-tax dollars. For both Roth and traditional IRAs, there are several events that will exempt withdrawals from the 10% tax penalty, such as:
- Up to $5,000 for the birth or adoption expenses
- Up to $10,000 for qualified first-time homebuyers
- Terminal illness
- Unemployed health insurance
Multiple Retirement Accounts
Another option is to use a provision in Rule 72(t) that also allows qualifying individuals to penalty-free withdrawals before age 59½. To do so, you must take a series of substantially equal periodic payments (SoSEPP) of at least five payments. The amount of the payments is calculated through one of three IRS-approved methods—required minimum distribution (RMD), amortization, or annuitization. You choose which of the three calculation methods you want).
The IRS has a full list of exceptions to tax on early distributions.
Should I Use the Rule of 55?
Whether or not you should use the Rule of 55 depends on your unique financial situation. It’s worth consulting with a financial advisor for expert advice.
The longer you keep money in a retirement account, the higher your potential compounding returns. Generally, if you can wait longer to withdraw money, it’s recommended to wait. You might have alternative income sources that would be better to prioritize.
However, if you need to take distributions to cover essential expenses, it’s likely better to take retirement withdrawals than to go into debt. Carefully consider your options and crunch the numbers before making your decision.
Related: You May Want to Skip These Popular Retirement Rules
