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The rule of 55 for 401(k) early withdrawal: What it is, how it works

  • The rule of 55 is an IRS provision that allows those 55 or older to withdraw from their 401(k) early without penalty.
  • The exception may apply to those who are leaving their employer, either voluntarily or involuntarily. 
  • The rule of 55 only applies to your current workplace retirement plan and doesn’t spare you from paying regular income tax on the withdrawal.
  • Visit Insider’s Investing Reference library for more stories.

It’s easy enough to contribute to a 401(k) or 403(b) plan. But getting your money back out of these workplace retirement accounts can be more difficult. Unless you’re at least 59½ years old, it usually triggers taxes and penalties. 

But those who have reached the age of 55 have a special option to access their funds penalty-free. This “rule of 55” could save serious money if you want to retire early or need to make a one-time withdrawal from your plan to cover a major expense.

What is the rule of 55?

To discourage the use of retirement plan funds for non-retirement expenses, the IRS normally doesn’t allow you to withdraw from your 401(k) early — “early” being defined as before age 59½. 

If you do, you’re dinged with income taxes — an automatic 20% of the amount you take out — plus an additional 10% tax penalty.

But the IRS makes an exception for the middle-aged. It spares you the 10% penalty if you have parted ways with your employer and are over 55 years old. If you’re a public safety worker (police or corrections officer, fire fighter, EMS responder), you can be as young as 50.

The rule of 55, as it’s colloquially known, can apply whether you quit your job voluntarily or are fired. But the departure must happen after you reach the appropriate age. So if you retired at age 54, you wouldn’t be eligible for the rule of 55, even after your 55th birthday.

Bear in mind that the rule of 55 does not remove your income tax obligations on your 401(k) withdrawals — only the 10% penalty. With a traditional 401(k), that means you owe tax on any amount you take out. With a Roth 401(k), that means any earnings generated by the account, if you’ve held it for less than five years.

Limits of the rule of 55 

Of course, the IRS never makes anything simple. Here are key limitations to keep in mind with the rule of 55 and your eligibility:

  • It has to be a 401(k). One common misunderstanding with the rule of 55 is that it applies to all retirement accounts. But, in fact, IRAs are not eligible for this exception.
  • It only works with your current 401(k). So any money sitting in an account from an old job isn’t covered by the rule of 55.
  • It may not apply to your 401(k). While employers can allow early distributions (IRS-speak for withdrawals) to departing 55-year-old employees, they are not obligated to do so. So it’s crucial to ask your company’s 401(k) plan administrator if early withdrawals, and hence the rule of 55, are allowed. 

How to take advantage of the rule of 55

The rule of 55 could be a deciding factor for those who are considering early retirement. It also helps if you’ve been unexpectedly downsized, and need a sizable sum right away: to cover medical bills, or pay off your mortgage early. While it’s usually advisable to keep money in your plan as long as possible, there can be times when tapping it makes financial sense.

As mentioned previously, IRAs and 401(k)s from previous employers are not eligible for the rule of 55 exception. However, the money in these other qualified retirement accounts can become eligible by rolling them into your current 401(k).

This is a big deal as it could help you access a much larger savings pool before age 59½. Of course, since only active employees can do rollovers, you’d have to square all this away before you leave the job. And check with your employer to see if it allows rollovers into its 401(k) plan (not all do). 

In any case, you should consider the timing of your withdrawal. Taking it in the year that you retire will increase your taxable income and could bump you into a higher tax bracket. So waiting to make your first withdrawal until at least the next January after your job exit could save you money on your tax bill.

Alternatives to rule of 55 withdrawals

If you don’t meet the eligibility requirements for the rule of 55, or even if you do, there may be other ways to avoid the 10% penalty. 

One option would be to set up a Substantially Equal Periodic Payments (SEPP) plan. You can establish one of these plans at any age. But you must agree to receive equal payments for at least five years or until age 59½ (whichever is later). 

Second option: See if you qualify for another IRS exception because you’ve become disabled or are dividing assets in a divorce. Other hardship distributions apply to home expenses, medical expenses, and other dire financial needs.

Finally, under the CARES Act, the IRS is allowing anyone up to $100,000 of penalty-free coronavirus-related withdrawals until December 31, 2020. 

The financial takeaway

Just because the rule of 55 makes penalty-free withdrawals possible, it doesn’t necessarily mean you should rush to tap your 401(k). The longer your money is invested, the more time you give your investments to grow tax-deferred, and for compound interest to work in your favor.

But you may ultimately decide that an early 401(k) withdrawal is the right move for your situation. And by taking advantage of the rule of 55, you can send more of those withdrawals to your own pocket and less to the IRS.

Related Coverage in Investing:

The worst thing you can do with your 401(k) when you leave a job, according to a financial expert and bestselling author

A 401(k) can be the most lucrative way to save for retirement, so take advantage if you can

If you work for a nonprofit, church, or public school, a 403(b) plan is a great way to save for retirement

How to withdraw from your traditional 401(k) account early — the strategies to avoid penalties and fees

Here’s exactly how to figure out when you can retire

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