Everything You Need To Know About The Rule Of 55

The rule of 55 is an early withdrawal rule that applies to 401k and 403b plans. Under normal IRS rules, withdrawals taken from a traditional 401k before the age of 59 and half will be subject to a 10% penalty in addition to any applicable income taxes unless an exemption applies.

However, the rule of 55 allows you to take penalty free withdrawals from your 401k account if you leave your job during the year you turn 55. Please note that you will still be required to pay any applicable income taxes on withdrawals. The rule of 55 simply allows you to get early access to your money when you meet the criteria of the rule.

The first guideline surrounding the rule of 55 is that you must turn 55 years old or be 55 years old in the year you take an early withdrawal. For example, say it is currently August 2024 and you are 54 years old. If your birthday is in September of 2024, you would be eligible for the rule of 55 for 2024 as you will turn 55 in 2024.

However, say that your birthday was not until March in 2025. In order to qualify for the rule of 55, you would have to wait until 2025 to take a withdrawal. If you took a withdrawal in 2024, you may be subject to a 10% IRS penalty in addition to the applicable income taxes.

The rule of 55 is only available if you are separated from your employer. This may mean that you left voluntarily for another job, lost your job, or simply retired. The IRS does not care about the reason you are no longer employed with your previous employer.

You have to combine this guideline with the first one talked above. So, if you are looking if the rule of 55 is applicable to you, ask yourself the following question. Am I 55 or going to turn 55 in the year that I am looking to take an early withdrawal and am I separated from my employer?

The rule of 55 is only applicable to your most recent 401k plan. If you have other 401k plans from previous jobs, you are not allowed to take penalty free early withdrawals from them under the rule of 55. For example, say you have been working at Company A for the past 6 years and have built up an account balance of $70,000.

You previously worked for Company B in which you have $500,000 in your 401k and Company C in which you have $350,000. Say that you recently left Company A and were going to turn 55 in the year that you left. You would be able to use the rule of 55 for your 401k at Company A.

You would not be able to use the rule of 55 to access the funds from the 401k plans at Company B and Company C. Additionally, the rule of 55 cannot be used for IRA accounts such as a Traditional or Roth IRA. It only applies to 401(k)s and similar retirement accounts.

It is important to be clear that the rule of 55 exempts you from paying the 10% IRS penalty that is normally applicable if you take a withdrawal from a 401k account before you are 59 and a half years old. The rule of 55 does not alleviate you from the responsibility of paying any applicable income taxes on early withdrawals.

401k withdrawals are added onto your income for the year. So, if you made $70,000 during the year from your job and then took a $10,000 withdrawal, your new taxable income for the year would be $80,000. Taxes must be paid even when taking an early withdrawal under the rule of 55.

The IRS typically requires 401k plan record keepers to withhold a minimum of 20% of withdrawals for taxes. However, the taxes you will pay may be different. If you are considering using the rule of 55, make sure to understand the tax implications and speak with a tax professional to get accurate tax advice.

You are allowed to return to work and continue using the rule of 55 as long as you follow all applicable rules. For example, say that you were working at Company A and left that employer in the year you turned 55. In this scenario, you would be able to use the rule of 55 for the 401k plan you had at Company A.

However, say that you are not quite ready to retire, but have enough money where you get another job in which you only work part time. Say this new part time job is at Company B. If you needed to supplement your income until you fully retired, you would be able to use the funds from your 401k at Company A to do so.

Like most financial questions, the answer is that it depends. For some, the rule of 55 can be a good way to access their retirement funds early without incurring an IRS penalty. For others, the rule of 55 is simply a way to justify an early retirement before they are truly ready.

The obvious advantage to the rule of 55 is that it can help facilitate an early retirement. If you plan to retire before you are 59 and a half, the rule of 55 can reduce the cost of any applicable withdrawals by eliminating the need to pay the 10% IRS penalty if you meet all criteria to use the rule of 55.

The rule of 55 stands under the umbrella of just because you can do something does not mean you should. For some investors, their retirement will only be hurt if they take early withdrawals from their 401k or 403b plans.

A spend down plan is a key part of a retirement plan. In other words, how and in what order you spend your assets you have built up. You need to ensure that you are truly prepared for retirement and have enough money to last your life expectancy before using the rule of 55.

As previously mentioned, the rule of 55 does not apply to IRAs. However, there is a special provision with Roth IRAs that can allow you to access some of the money in the account penalty free. Roth IRAs allow you to contribute after tax dollars to the account.

When you retire, you can pull the money out tax free as long as all rules are followed. Since contributions are made with after tax dollars, you can pull these base contributions out at any time without incurring an IRS penalty or taxes.

Keep in mind this is only applicable to your contributions and not to the earnings in the account. Similar to pulling money early from a 401k, you must ensure pulling money early from a Roth IRA will not derail your retirement. With that being said, it is another option to access your retirement money early if you have a Roth IRA.

A brokerage account is the standard investing account that allows you to buy most investments, but does not offer any special tax treatment like 401(k)s or IRAs. However, taking an early withdrawal from a brokerage account may end up being cheaper than a rule of 55 withdrawal from a 401k or 403b due to the tax treatment of brokerage accounts.

Brokerage accounts are taxed at either short or long term capital gains tax rates. Short term capital gains (assets held less than a year before selling) rates are the same as your ordinary income, but long term capital gains (assets held for more than a year) are taxed at 0%, 15%, and 20%.

This means that it could end up being cheaper in terms of taxes to pull money from a brokerage account than it would be to take a rule of 55 withdrawal from a 401k or 403b if your tax rate is higher in these accounts than it is in a brokerage account.

401k loans allow you to borrow from the balance that you have built up in your 401k account. 401k plans are not required to offer loans as a part of the plan. If you are looking at taking a 401k loan, double check that your specific plan allows you to do so.

You are allowed to borrow up to 50% of the vested balance up to a maximum amount of $50,000. Your vested balance simply refers to the amount of money in the account that is fully owned by you. Your contributions are always owned by you, but an employer match may have a vesting schedule in which the money they contribute will not be yours immediately.

401k loans are unique in that the loan amount and interest is paid back to you and not a lender. For example, say you had a $50,000 401k balance and took out a loan for $10,000. As you pay back this $10,000 loan the principal payment and interest goes back into your account and not to a lender.

With that being said, the repayment terms of 401k loans can be restrictive. In general, you must repay your loan within 5 years in level payments such as weekly, biweekly, monthly, or quarterly. Additionally, some plans will require you to repay your loan balance in full if you leave your job or lose your job.

Failure to repay a 401k loan can result in a taxable event which we will look at later on. 401k loans may be a way to access your retirement money early without incurring a penalty, but just like the rule of 55 there are drawbacks so be very careful before taking a 401k loan if allowed by your plan.  

Beyond the rule of 55, there are a few other excemptions that may allow you to access money from your applicable retirement account without incurring a 10% penalty. Reasons can include the death of the plan participant.

The total and permanent disability of the plan participant. Payments under a qualified domestic relations order. Military reservists called to active duty. Unreimbursed medical expenses greater than 10% of adjusted gross income.

The bottom line is that the rule of 55 allows you to take an early penalty free withdrawal from your most recent 401k or 403b plan as long as all applicable rules are followed. Keep in mind that you will still be responsible for any applicable taxes on early withdrawals that you take.

The rule of 55 can be advantageous if you are looking to retire early and want to reduce the costs of withdrawals, but for many people it may be better to not take an early withdrawal. Working with a financial professional such as a financial advisor can be a good idea if you need help navigating these types of issues.