For individuals with an employer-sponsored retirement account like a 401(k) who are considering early retirement or are in need of funds due to job loss towards the end of their career, the rule of 55 can be a valuable resource. It can serve as a financial safety net for those seeking cash flow options when other alternatives are limited.
Let’s delve into how the rule of 55 operates and whether it could be a viable option for you.
Understanding the rule of 55
The rule of 55 is a provision by the IRS that permits individuals who leave their job for any reason to begin taking penalty-free distributions from their current employer’s retirement plan in the year they turn 55 or later. This provision allows early retirees or those in need of immediate cash flow to access their retirement funds earlier than the standard age requirements.
Typically, withdrawing funds from a tax-qualified retirement plan, such as a 401(k), before reaching the age of 59½ incurs a 10 percent early withdrawal tax penalty. However, with the IRS rule of 55, individuals may be able to receive distributions starting at age 55 without triggering the early penalty, provided their plan allows for such distributions.
Although the distribution is exempt from the early withdrawal penalty, it is still subject to a 20 percent income tax withholding rate. Any excess withholding will be refunded when filing your annual tax return.
It’s important to note that the rule of 55 does not apply to traditional or Roth IRAs.
Utilizing the rule of 55 for early retirement
While many companies offer retirement plans that accommodate the rule of 55, it’s essential to confirm whether your employer provides this option.
“Some companies view this rule as an incentive for employees to resign in order to access penalty-free distributions, potentially depleting their retirement savings prematurely,” explains Paul Porretta, a compensation and benefits attorney at Troutman Pepper in New York City.
Before considering a rule of 55 withdrawal, here are the prerequisites and other factors to consider:
- Plan availability: Your employer must offer a qualified retirement plan, such as a 401(k) or 403(a) or (b), that permits rule of 55 withdrawals.
- Age requirement: You must depart from your position (voluntarily or involuntarily) in the year you turn 55 or later.
- Funds retention: Funds must remain in the employer’s plan until withdrawal, and you can only withdraw from your current employer’s plan. Transferring funds to an IRA forfeits the tax protection under the rule of 55.
- Consider potential gains: Understand that early withdrawals may result in forfeiting potential investment gains.
- Tax optimization: Consider commencing withdrawals at the start of the following calendar year when your taxable income may be lower if you are not employed.
- Public safety exception: Qualified public safety workers (such as police officers, firefighters, EMTs) may be eligible to begin withdrawals five years earlier. Ensure your plan allows withdrawals in the year you turn 50.
Prior to making any financial decisions, consult with a trusted advisor or tax professional to avoid unforeseen consequences.
Is the rule of 55 suitable for you?
Deciding whether to pursue early withdrawals under the rule of 55 hinges on your individual financial circumstances. Familiarize yourself with your plan’s regulations, determine the necessary withdrawal amount, and estimate your anticipated annual expenses during early retirement. These considerations will guide your decision on whether early withdrawal aligns with your financial goals.
Instances where early withdrawals may not be advisable include:
- Tax implications: The combined income from the withdrawal and other sources may push you into a higher tax bracket.
- Lump sum requirement: Your plan might mandate a lump sum withdrawal, potentially subjecting you to higher taxes and limiting future retirement income.
- Age restrictions: Initiating withdrawals before turning 55 is not permissible and incurs the 10 percent early withdrawal penalty.
Additional considerations
When contemplating a rule of 55 withdrawal, take the following factors into account:
- Single plan access: The rule applies solely to your current or most recent employer’s plan. If you have funds in multiple former employer plans, consider rolling them over to the current plan before leaving the employer.
- IRA rollover: Traditional or Roth IRA funds can be transferred to your current plan while still employed for early access.
- Continued withdrawals: Even if you secure another job before reaching 59½, you can still withdraw funds from your former employer’s plan.
- Strategic withdrawals: Timing withdrawals strategically during low-income years can optimize tax savings, especially if a higher tax rate is anticipated in the future.
“The primary advantage of the rule of 55 is avoiding the 10 percent penalty,” notes Porretta. “However, sacrificing tax deferral can prove more valuable if non-tax-qualified resources cover expenses in the near future, allowing you to preserve the 401(k)/403(b) distribution for later years.”
Alternative early withdrawal options for 401(k)
Several exceptions exist that enable penalty-free access to retirement funds, depending on specific circumstances.
The 72(t) option allows withdrawals from a 401(k) or IRA at any age without penalty, known as SEPP (substantially equal periodic payments). These payments are exempt from the 10 percent early withdrawal penalty and must continue for five years or until reaching age 59½, whichever comes later.
Other scenarios exempt from the early withdrawal penalty include:
- Total and permanent disability
- Distributions due to qualified disasters
- Certain distributions to qualified reservists on active duty
- Medical expenses exceeding 7.5 percent of adjusted gross income
- Victims of domestic violence
Furthermore, the IRS offers additional exceptions to the early withdrawal penalty.
Final thoughts
While withdrawals post-age 59½ are typically penalty-free, the rule of 55 can be a viable option for those contemplating early retirement if financially secure. However, if commencing withdrawals at age 55 is inevitable until securing another source of income, the rule of 55 may serve as a temporary solution.
It is essential to conduct thorough research and seek professional advice before making any investment decisions. Past performance is not indicative of future price appreciation.