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What is the Rule of 55?

What is the Rule of 55?
Catherine Hiles
Updated December 27, 2021
4 Min Read

Most people dream of the day they can ditch their work clothes and retire for good. But before you can retire, you need to know that you can support yourself and your family without your income. For that reason, many Americans save for retirement using an employer-sponsored 401(k) or 403(b).

But saving for retirement using this method comes with a caveat. A retirement account like a 401(k) comes with government tax breaks as a way to incentivize workers to save for their golden years.

Normally, you are required to wait until age 59 ½ to withdraw funds from your employer-sponsored retirement account. Attempting to withdraw money prior to that will result in you paying a penalty of 10%.

But once you turn 55, there is a loophole that makes it possible for you to access your 401(k) or 403(b) money penalty-free. It’s called the rule of 55.

How the rule of 55 works

The rule states that you may make early withdrawals without penalty if you leave your job in the calendar year in which you turn 55 or after. This applies whether you leave your job voluntarily or not. So if you wanted to retire a few years early at 55, you could quit your job and use the rule of 55 to access your retirement savings before you turn 59 ½. 

Alternatively, if you are laid off close to retirement, you could access your retirement funds early provided you are at least 55 years old.

When does the rule not apply?

If you want to retire early at 53, you would need to wait until 59 ½ to access your 401(k) savings. The rule of 55 only applies if you leave your job between the ages of 55 and 59 ½.

The rule also doesn’t apply to any retirement savings accounts from previous jobs. You can only use the rule of 55 for your most recent employer’s 401(k) or 403(b). So if you have other accounts from your previous jobs, you won’t be able to access those funds using the rule of 55.

The rule also doesn’t apply to individual retirement accounts, or IRAs

How else can you avoid the 401(k) withdrawal penalty?

If you need to access your 401(k) funds before you turn 55, there are a few additional loopholes that can help you avoid paying that painful 10% penalty. 

Substantially equal periodic payments

One way to access the money in your retirement account without paying a penalty is to use a substantially equal periodic payment, or SEPP, plan. This allows you to withdraw a certain amount from your 401(k) or 403(b) every year for five years. The withdrawal amount is calculated and set by the IRS.

Once you sign up for an SEPP plan, you have to stick it out for the full five years, or until you turn 59 ½ (whichever comes first). So you need to make sure that this is a good option for you before signing up, as you won’t have the option to back out if you change your mind.

Divorce

You may be required by court order to split your 401(k) with your former spouse as part of a divorce proceedings. In that case, you could access the funds without paying the 10% penalty.

Medical expenses

You can use 401(k) funds to help pay medical expenses if they exceed 7.5% of your adjusted gross income. In this case, you wouldn’t be required to pay the penalty.

College tuition

If you need money to pay college costs (including tuition, fees, room, and board) for yourself or your spouse or dependents, you may be able to access 401(k) funds without paying the penalty.

Active duty status

If you are in the military reserves and get called to active duty, you can access your retirement savings to help pay living expenses without having to pay the 10% penalty

Disability

The 10% penalty doesn’t apply if you become permanently disabled. In this case, you could access the funds immediately and penalty-free.

Childbirth or adoption

If you have expenses within a year after giving birth to or adopting a child, you would be able to access your 401(k) funds without paying the penalty.

Disaster relief

If you were the victim of a natural disaster like a hurricane or tornado, you may be able to withdraw 401(k) funds penalty-free if the IRS granted relief.

Death

After your death, funds from your 401(k) may be withdrawn without the 10% penalty in order to make payments to your estate or your beneficiaries.

When should you use the rule?

If you are in your mid-50s and stuck in a job you hate, the rule of 55 would allow you to leave your job and retire early and still have an income.

Similarly, if you are terminated from your job at 55 or older, you could use your 401(k) funds to live off rather than scrambling to find another job. If you can swing it, that could be a good alternative than having to go back to square one with interviewing (and competing against much younger applicants).

One important thing to remember is that if you use the rule of 55 to access your retirement savings early, you can still go back to work if you choose. So, if it makes sense for your situation, you could take 401(k) withdrawals and also get a part-time or full-time job doing something you enjoy. This is a good option if you enjoy working, or need to stay busy.

Another reason to use the rule of 55 is if you want to decrease the required minimum distributions, or RMDs, that you are required to take when you turn 72. At that age, the IRS will determine how much you are required to withdraw based on the amount of money in your account and your life expectancy. If you have a lot of money in your 401(k) when you reach 72, your RMDs may be substantial. And, depending on the tax situation at that time, you may end up paying a lot more in taxes than you planned. Withdrawing some of the funds using the rule of 55 will mean that there is less money in your 401(k) when you turn 72, and could save you a lot in taxes.

Summary

If you think that the rule of 55 is a potential option for you, it’s a good idea to talk to a tax professional to make sure you’re not going to end up running out of savings as you age. But if you have the means, it can provide a realistic way for you to retire early without having to worry about running out of money toward the end of your life.

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