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Are you considering early retirement? Consider taking advantage of the Rule of 55 to tap into your 401(k) or 403(b) account. However, before doing so, make sure you understand the Rule of 55 with these 5 important facts to avoid penalties and maximize your savings.
Understanding the Term “Rule of 55” and IRS Guidance
As far as I can tell, the term Rule of 55 is not officially used by the IRS, but it is widely recognized in the financial industry. While I couldn’t find an IRS publication dedicated solely to this rule, the Age chart for participants in the IRS topic Retirement topics – Significant ages for retirement plan participants ↗ references age 55 as follows:
An employee who receives a distribution from a qualified plan after separation from service is not subject to the 10% additional tax on early distributions ↗ if the distribution occurs in the year of turning 55 or older. This is also referenced under Internal Revenue Code section 72(t).
If you’re considering taking advantage of this exception, I highly recommend that you consult financial or tax advisor to ensure compliance.
Here are 5 important facts to understand the Rule of 55:
1. Eligibility Age of 55
The Rule of 55 applies if you leave your job during or after the year you turn 55.
An exception exists if you’re a public safety employee—the rule applies if the distribution occurs in the year of turning 50 or older.
2. Applicable to Current Employer 401(k) or 403(b) Plans
The Rule of 55 only applies to the 401(k) or 403(b) plan of your current employer. Funds in IRAs or old 401(k) and 403(b) accounts are not eligible.
If you try to access funds from any of these tax-deferred plans before you are 59½, you will still face penalties. However, there are exceptions such as withdrawals for certain medical expenses, disability, or other specific situations outlined by the IRS.
Always check if your specific 401(k) or 403(b) plan permits early withdrawals under this rule. Plan rules can vary, so it’s essential to ask your employer about these details. Different employers may have unique terms and conditions, impacting your ability to withdraw.
3. No Penalty for Early Withdrawal
The 10% penalty for early withdrawals is waived.
Of course, once you reach the age of 59½, you can withdraw from your 401(k), 403(b), or IRA accounts penalty-free.
4. Keeping Funds in Your 401(k) or 403(b) Plans and Working Later
The Rule of 55 applies only to your current employer’s 401(k) or 403(b) plan. If you roll the balance into an IRA, you lose the ability to take penalty-free withdrawals. It’s crucial to leave the funds in the employer’s plan until at least age 59½.
Additionally, you can continue withdrawing from your 401(k) or 403(b) even if you start a new job, as long as the withdrawals are from the plan of the employer you left at age 55.
5. Tax Implications
While the Rule of 55 allows you to bypass the early withdrawal penalty, your withdrawals are taxed as ordinary income and there is a 20% mandatory withholding.
Larger withdrawals can push you into a higher tax bracket, so managing the amount you withdraw can help minimize your tax burden.
Summary
While the Rule of 55 can provide immediate financial flexibility, it’s important to balance short-term needs with long-term retirement goals, especially considering the tax implications and the potential impact on your future savings. Ensuring that you have other forms of income or savings planned for the future is crucial in maintaining your financial health.
And remember, it’s always a great idea to chat with your financial or tax advisor to make sure your decisions are right on track and aligned with the latest guidelines and laws.
For more information on retirement, see our category page, Retirement.