How to Use the Rule of 55 to Take Early 401(k) Withdrawals

Learn your options for accessing funds in your 401(k) or 403(b) if you retire early.

There are often penalties attached to taking early withdrawals from retirement accounts, but there are also some exceptions. One exception to the 401(k) early withdrawal penalty is known as the rule of 55, and it can allow you to take distributions from your 401(k) or 403(b) without having to pay a penalty.

To use the rule of 55, you’ll need to:

• Be at least age 55 or older.
• Have a 401(k) or 403(b) that allows rule of 55 withdrawals.
• Have left your employer voluntarily or involuntarily in the year you turn 55 or later.
• Leave your funds in an active 401(k) or 403(b) plan.

Here is a look at how the rule of 55 works, and what to consider before withdrawing any funds.

What Is the Rule of 55?

If you take an early withdrawal from a 401(k) or 403(b) before age 59 1/2 you will generally have to pay a 10% early withdrawal penalty. However, the IRS has established the rule of 55, which allows those who leave a job in the year they turn 55 or later to remove funds from that employer’s 401(k) or 403(b) without having to pay a 10% early withdrawal penalty. “You are able to use this rule regardless of whether you decide to retire early or if you are laid off from your job – the terms of separation are not important,” says Katie Kavehrad, a financial planner at Paradigm Wealth Partners in Knoxville, Tennessee.

Who Can Use the Rule of 55?

To be eligible for the rule of 55, you’ll need to leave your job during or after the calendar year in which you turn age 55. The rule allows penalty-free 401(k) withdrawals for workers between ages 55 and 59 1/2 who leave a job during that age range. However, you cannot quit your job when you are age 52 and ask to start early distributions at age 55, unless you qualify for a hardship withdrawal.

In addition to meeting the age criteria, you’ll want to check if your employer offers this benefit. Companies are not required to have 401(k) or 403(b) plans that allow for penalty-free withdrawals starting at age 55. If your employer does offer rule of 55 distributions, they may have rules surrounding the methods of withdrawal. Some employers may allow you to set up a distribution schedule, while others could offer a lump sum withdrawal.

Public safety workers may be able to take penalty-free retirement account withdrawals starting five years earlier, at age 50. If you work in the police force, air traffic control, as a firefighter or in other areas of public safety, you may qualify for early withdrawals.

If you meet the age criteria and your employer offers the rule of 55, you will be able to take penalty-free funds from the 401(k) plan associated with the job you recently left. “The main caveat to this rule is that the retirement account must be active, so it cannot be one with a previous employer that was never rolled over,” says Josh Simpson, vice president of operations and an investment advisor with Lake Advisory Group in Lady Lake, Florida.

Advantages of the Rule of 55

If you need to retire for health reasons or are asked by an employer to retire, the rule of 55 allows you to gain access to your retirement funds without penalty. “The rule of 55 was developed to help people who decide to retire, whether by their choice or their employer’s, to be able to take money out of their retirement accounts such as a 401(k) or 403(b) prior to the age of 59 1/2 without paying the 10% penalty,” Simpson says.

The rule of 55 makes it easier to withdraw funds from your retirement account after you retire early. The process of withdrawing from a 401(k) or 403(b) at age 55 or after is typically simple to set up and allows early retirees who need the funds to keep more of their retirement savings.

Disadvantages of the Rule of 55

Taking funds out of an account designed for retirement starting at age 55 could lead to missed earnings, depending on how your investments perform. “The earlier you withdraw, the less opportunity you have for your balance to grow over time for use later in retirement,” says Paul Tyler, chief marketing officer at Nassau Financial Group in Hartford, Connecticut. Those who retire in their 50s may have a long retirement ahead of them, and withdrawing from a retirement account starting at a young age could cause it to deplete more quickly.

The amount you withdraw from a tax-deferred 401(k) or 403(b) will be taxed as regular income. If you take out $40,000 from your 401(k) through the rule of 55, it will be considered as an additional $40,000 in income for the year for tax purposes. “This could have unintended consequences, such as moving you into a higher tax bracket,” Simpson says.

The extra income from a 401(k) or 403(b) withdrawal could impact your government retirement benefits if you have an older spouse receiving Social Security or Medicare. If you file taxes jointly and your income goes up for the year because of the 401(k) distribution, the higher income could mean increased Medicare premiums for your spouse or more of their Social Security income being taxable at the end of the year.

The rule of 55 only allows for penalty-free early withdrawals from an employer retirement account such as a 401(k) or 403(b). If you roll the money over to an IRA, you will need to wait until age 59 1/2 to avoid the early withdrawal penalty.