If you’ve been contributing to a 401(k) or other employer-sponsored plan, you likely know that age 59 ½ is the magic number. That’s when you can start to withdraw your savings without incurring a steep tax penalty. But there is an exception that allows you to access your money earlier known as the rule of 55.
At Advance Capital Management, we know that age is just a number, not a retirement mandate. Many people retire way earlier or way later than the average retirement age of 62. Regardless of what age you choose to retire, it’s important to create an appropriate withdrawal strategy for your situation.
The rule of 55 gives you more flexibility, especially if you want to retire early. Here are the most important considerations for taking advantage of the 401(k) rule of 55.
This article covers the following:
What is the rule of 55?
Rule of 55 cautions
Who should consider the rule of 55?
What is the rule of 55?
The rule of 55 is a provision that allows individuals who are 55 years old or older to withdraw funds from their employer-sponsored retirement plans, such as a 401(k), 403(b) or the Thrift Savings Plan (TSP), without incurring the usual early withdrawal penalty.
Under normal circumstances, if you withdraw money from these retirement accounts before reaching the age of 59 ½, you would typically be subject to a 10% penalty on top of any income taxes owed. However, the rule of 55 provides an exception to this penalty for individuals who meet the specified criteria.
To make use of the rule of 55, you must have separated from the employer associated with the retirement plan in the year you turn 55 or later. This separation could occur due to retirement, resignation or being laid off.
It's important to note that the rule of 55 applies only to the retirement plan associated with your current employer. If you have retirement accounts from previous employers or IRAs, the rule of 55 does not apply to those accounts.
Rule of 55 cautions
While the rule of 55 can be a useful provision for individuals planning early retirement or leaving their employer at age 55 or older, it's important to be aware of some cautions and considerations:
Tax implications – Although the rule of 55 allows for penalty-free withdrawals from employer-sponsored retirement plans, it doesn't exempt you from paying income taxes on those withdrawals. Any funds withdrawn will be subject to ordinary income tax based on your tax bracket. Therefore, it's crucial to understand the potential tax impact and consider tax planning strategies when utilizing the rule of 55.
Long-term financial security – Withdrawing funds from your retirement account before reaching traditional retirement age can affect the longevity of your savings. Consider the potential impact on your overall retirement income and ensure that the withdrawals align with your long-term financial goals. It's recommended to work with a financial adviser to evaluate the sustainability of your retirement plan.
Furthermore, it's crucial to understand that the rule of 55 is a one-time opportunity. Once you begin withdrawing funds from your retirement account under the rule of 55, you cannot restart the clock or use this provision again in the future. It's a unique provision available only during the year you turn 55 or later and upon separation from your employer.
The rule of 55 isn’t for everyone. It greatly depends on your specific financial circumstances and goals. But here are a few scenarios where someone might want to take advantage of the rule of 55:
Early retirement – If you plan to retire before reaching the age of 59 ½ and have a substantial amount of savings in your employer-sponsored retirement plan and other assets, the rule of 55 can be beneficial. It allows you to access those funds penalty-free to support your early retirement lifestyle.
Career change – You may decide to leave your current job at the age of 55 or older to pursue a new career, start a business or explore other opportunities. If you have accumulated retirement savings in your employer-sponsored plan, the rule of 55 can help you access those funds without penalties while transitioning to a new phase of your professional life. Just keep in mind the long-term impact on your retirement income needs.
Financial need – Life circumstances may arise where you require access to your retirement funds to cover unexpected expenses or financial emergencies. If you meet the age and employment separation requirements, the rule of 55 can provide a penalty-free option to tap into your retirement savings temporarily.
It's important to note that the rule of 55 may not be suitable for everyone in these situations. Before making any decisions, consider factors such as your overall financial situation, retirement goals, tax implications and any potential impact on your long-term financial security. Consulting with a financial adviser is highly recommended to determine if the rule of 55 aligns with your specific needs and goals.
Remember, retirement planning is a complex process, and utilizing the rule of 55 is just one aspect to consider. Taking a comprehensive approach and seeking professional guidance can help you make informed decisions and optimize your retirement strategy.
Ryan is a financial adviser committed to helping people feel confident and secure in their financial lives and future. Working closely with clients, he incorporates all elements of their lives into personalized financial plans, including investment portfolio advice, tax strategies and saving for college. He is a CERTIFIED FINANCIAL PLANNER™ professional.