What is the Rule of 55 and how does it work?

The Rule of 55 may benefit workers with an employer-sponsored retirement account, such as a 401(k), who wish to retire early or need access to funds if they have lost their employment towards the end of their career. It can be a lifesaver for workers who need cash and don’t have other good alternatives.

Here’s how the rule of 55 works and whether you should consider using it.

What is the rule of 55?

The Rule of 55 is an IRS provision that allows workers who leave their jobs for any reason to begin receiving penalty-free distributions from their current employer’s retirement plan once they reach retirement age. 55 years. It allows those looking to retire earlier than normal or those in need of cash flow a way to take distributions from their retirement plans earlier than is generally allowed.

Taking a distribution from a tax-qualified retirement plan, such as a 401(k), before age 59½ is generally subject to a 10% early withdrawal tax penalty. However, the IRS rule of 55 may allow you to receive a distribution after you reach age 55 (and before age 59½) without triggering the early penalty if your plan provides for such distributions.

However, any distribution would still be subject to a 20% income tax withholding rate. (If 20% turns out to be more than you owe based on your total taxable income, you’ll get a refund after you file your annual tax return.)

It is important to note that the Rule of 55 does not apply to all 401(k)s and is not available at all for traditional or Roth IRAs.

How to Use the Rule of 55 to Retire Early

Many companies have pension plans that allow employees to take advantage of the rule of 55, but your company may not offer this option.

“401(k) and 403(b) plans don’t have to have the 55-withdrawal rule, so don’t be surprised if your plan doesn’t allow it,” says Paul Porretta, compensation and benefits attorney at Troutman Pepper, a law firm based in New York, NY.

“Many companies see the rule as an incentive for employees to quit in order to get a payout without penalty, with the unintended consequence of depleting their retirement savings prematurely,” he says.

Here are the conditions that must be met and other things to consider before taking an out rule of 55.

  • The pension plan offers them. Your company’s plan offers a 401(k) or 403(a) or (b) that allows for the 55-withdrawal rule. Some plans prohibit withdrawals before age 59½ or even age 62.
  • 55 or older. You leave a position (voluntarily or involuntarily) in or after the year in which you reach the age of 55.
  • The money must stay in the plan. You fully understand that your funds must be kept in the employer’s plan before withdrawing and you can only withdraw from your current employer’s plan. If you transfer them to an IRA, you lose the 55% tax protection rule.
  • Lost potential gains. You understand that early withdrawals mean the loss of any gains you might otherwise have made on your investments.
  • Reduce taxes. You can wait until the start of the next calendar year to start the 55-withdrawal rule when your taxable income is expected to be lower if you are not working.
  • Public safety worker. If you are a skilled public safety worker (policeman, firefighter, paramedic, correctional officer, or air traffic controller), you may be able to start 5 years earlier. Make sure you have a qualified plan that allows withdrawals in or after the year you turn 50.

However, as with any financial decision, be sure to consult a trusted advisor or tax professional first to avoid any unintended consequences.

Should you use the rule of 55?

Whether or not to take early withdrawals under the Rule of 55 will depend on your unique financial situation. You’ll want to have a clear understanding of your plan’s rules, how much you’ll need to withdraw, and your likely annual expenses during your early retirement years. Understanding these issues should help you know if an early withdrawal is the right decision for you.

Here are some situations where it is likely that early withdrawals would not be the right decision.

  • If it would push you into a higher tax bracket. The amount of your income for the year in which you begin the withdrawal plus the early withdrawal could put you in a higher marginal tax bracket.
  • If you are required to take a lump sum. Your plan may require a one-time lump sum withdrawal, which may require you to withdraw more money than you wish and subject you to ordinary income tax. These funds will no longer be available as a source of tax-efficient retirement income.
  • If you are under 55. You may want to leave your current employer before a year in which you turn 55 and start taking withdrawals at age 55. Note that this is NOT allowed and you will have to pay a 10% early withdrawal penalty.

Other Important Considerations

If you’re considering removing a 55 indent rule, you’ll also want to consider a few other things:

  • If you have funds in more than one former employer’s plan, the rule only applies to your current/most recent employer’s plan. If you have funds in multiple plans that you want to access using the Rule of 55, be sure to transfer those funds to your current employer’s plan (if they accept rollovers) BEFORE you leave the employer.
  • Funds from IRA plans that you might want to access early can also be rolled into your current plan (while still employed) and accessed that way.
  • If you wish, you can continue to make withdrawals from your former employer’s plan even if you found another job before you reached age 59½.
  • Be sure to time your withdrawals carefully to create a strategy that suits your financial situation. Withdrawing from a taxable retirement account in a low-income year could save you tax, especially if you think your tax rate may be higher in the future.

“Keep in mind that the only real benefit of the rule of 55 is avoiding the 10% penalty,” says Porretta. “Meanwhile, tax deferral is sacrificed, which may prove more valuable if other non-tax-eligible financial resources can cover expenses in future years, saving you the 401(k) distribution. )/403(b) to subsequent years.

Other 401(k) Early Withdrawal Exceptions

You may be able to access your retirement plan tax-free in a few other ways, depending on your situation.

There is an exception called option 72

  • Total and permanent disability
  • Distributions made due to qualified catastrophes
  • Certain distributions to qualified reservists on active duty
  • Medical expenses exceeding 10% of adjusted gross income
  • Withdrawals made to meet IRS obligations
  • But the IRS still offers other exceptions to the early withdrawal penalty.

    At the end of the line

    If you can wait until you’re 59½, withdrawals after that age are generally not subject to the IRS’ 10% penalty tax. However, if you are in a financially secure position to retire early, the Rule of 55 may be an appropriate course of action for you.

    But if you have no choice but to start withdrawals at age 55 until you can get another job, start a business, or otherwise create an income, the rule of 55 may be the short-term lifeline you’ve been looking for.

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    Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are cautioned that past performance of investment products does not guarantee future price appreciation.

    Maria D. Ervin