Normally, when you take an early distribution from your 401k plan, before the eligible withdrawal age of 59½, you’re required to pay a 10% penalty plus income taxes on your withdrawal.
For example, if you’re under the age of 59½ and take a distribution of $20,000, you’ll be required to pay $2,000 as an early distribution penalty. You’ll also have to pay income taxes on the withdrawal amount of $20,000.
However, some workplace retirement plans have a rule of 55 in place which can allow you to make an early withdrawal without penalties, if you’re at least 55 years of age and depart your employer.
What is the Rule of 55?
The rule of 55 is an IRS provision that can waive the 10% early distribution penalty if an employee is at least 55 years old when they depart from their employer.
It’s specific to workplace retirement plans, and does not apply to IRAs. Furthermore, it’s completely up to the employer whether to offer the rule of 55 provision in their 401k plans.
If a 401k plan has a rule of 55 provision, employees who are laid off, fired, or quit their positions after turning 55 years old can withdraw from their 401k without penalties. Income taxes are still applied to all withdrawals from pre-tax 401k accounts.
For example, if you’re 55 years of age and you get laid off from your position, the rule of 55 would allow you to withdraw from your 401k without the 10% penalty.
The rule of 50
Public safety workers have an additional provision that could allow them to withdraw 401k funds even earlier than 55 years of age. If you’re a public safety worker like a firefighter, police officer, or EMT, you may be able to use the same rules as the rule of 55 when you turn 50 years of age.
Does the rule of 55 apply to IRAs?
However, if your 401k plan accepts rollovers, you could choose to rollover your funds from your IRA into your 401k and use the rule of 55 to take distributions from your 401k.
What if I’m over 55 years of age but I’m not leaving my employer?
If your company’s 401k offers the rule of 55 provision in their plans, and you’re over 55 years of age but under 59½ years of age, you cannot use the rule of 55 if you do not depart your employer. In this case, a 401k loan could be the better option, if your plan allows it.
A 401k loan lets you borrow up to 50% of your account value, up to a maximum of $50,000. Interest rates are much lower than the early distribution penalty at prime rate plus one or two percent, and all interest payments get paid back to your 401k plan. You’ll have 5 years to repay the loan, or if you use the money to purchase a primary residence, you can get up to 15 years to pay it back.
What if I have old 401k plans with previous employers?
If you have old 401k plans from your previous employers, you cannot use the rule of 55 for older plans. The rule of 55 can be applied to retirement plans with your current and most recent employer. However, you could execute a rollover from your old 401k plans into your most current plan and use the rule of 55 to withdraw the total amount from all plans.
Should I use the rule of 55, if available?
If your employer’s 401k plan offers the rule of 55 provision, here are some considerations if you’re between the age of 55 and 59½, and are planning on leaving your employer:
- Are you in a lower tax bracket than you would be in future years? If you’re in a high tax bracket, it may not make sense to take distributions from your 401k until you’re making less income after leaving your employer.
- Are you required to take out a lump sum withdrawal? Some provisions may require that you withdraw your funds in one lump sum. Because you’ll have to pay income taxes on your withdrawals from a pre-tax 401k, it may be more cost-efficient to spread out your withdrawals in retirement after the age of 59½.
Will I still have to pay taxes on withdrawals using the rule of 55?
With the rule of 55, the 10% early distribution penalty is waived. However, you’ll still have to pay regular income taxes when making a withdrawal from your pre-tax 401k. If you take distributions from a Roth 401k, withdrawals are tax-free.
Do I need to retire if I take distributions with the rule of 55?
Many people use the rule of 55 to access their 401k funds and retire early. However, the rule of 55 does not restrict you from ever working again. You are allowed to continue working part-time or full-time with another employer.