Are you dreaming of an early retirement? Well, here’s a little secret that could make it possible – the rule of 55. This lesser-known IRS exception allows you to withdraw money from your 401(k) or 403(b) without facing the dreaded 10% penalty if you leave your job at or after the age of 55. Intrigued? Let’s dive into the details of how this rule works and whether it’s the right move for you.
How Does the Rule of 55 Work?
Under the rule of 55, the IRS gives you the green light to dip into your current employer-sponsored retirement plan before reaching the age of 59½ without facing a hefty penalty. But there are two conditions you must meet: the withdrawals must occur in the year you turn 55 or later, and you must have left your employer.
According to Nicole Birkett-Brunkhorst, a senior wealth planner at U.S. Bank private wealth management, this rule applies regardless of how your employment ended. However, it’s essential to note that you can only make withdrawals from your current employer’s 401(k) or 403(b) accounts. Old retirement accounts and IRAs are not eligible.
But wait, don’t celebrate just yet. While you can avoid the penalty, you’ll still owe taxes on the amount withdrawn. The IRS will withhold 20% for federal income taxes, so be prepared for that.
How Much Can You Withdraw Using the Rule of 55?
The good news is there’s no limit to the amount you can withdraw from your qualified retirement plan under the rule of 55. However, whether you can actually make these penalty-free withdrawals depends on your company’s plan. Not all employers allow them. So, before you start making plans, make sure to check with your employer and understand their rules.
It’s worth mentioning that the rule of 55 distributions must adhere to the terms of your qualified plan. For some plans, you might have the flexibility to determine how much you withdraw, while others may require you to liquidate the entire account in a lump sum. Be cautious because this could result in a substantial tax liability.
How Can You Make the Best Use of the Rule of 55?
Before jumping in and taking advantage of the rule of 55, it’s wise to consult with a tax expert and explore all your options. Early withdrawals can have both tax-saving benefits and potential drawbacks. Here are a few things to consider:
Income-Replacement Strategy
If you’re eyeing early retirement, the rule of 55 can serve as an excellent income-replacement strategy. Unlike other complex methods like substantially equal periodic payments (SEPP) plans, this rule gives you more flexibility in deciding how much you withdraw from your retirement account.
Tax-Planning Opportunities
Another advantage of the rule of 55 is the potential for tax planning. If you find yourself in a lower income tax bracket, taking advantage of penalty-free withdrawals could help you maximize lower federal tax brackets and reduce the size of your required minimum distributions in the future.
Reducing Retirement Savings Prematurely
While accessing your retirement funds early can be tempting, be cautious about reducing your savings prematurely. By withdrawing at 55, you miss out on potential tax-free growth between ages 55 and 73 when required minimum distributions start.
Provision for Public Safety Workers
Here’s an interesting twist. Public safety workers may be eligible for penalty-free withdrawals starting at the age of 50, five years earlier than the rule of 55 allows. This provision recognizes the unique circumstances of those working in these fields.
Other Ways to Avoid the Early-Withdrawal Penalty
The rule of 55 is just one of several options available to avoid the early-withdrawal penalty. Here are some alternatives worth considering:
Hardship Withdrawals
Under specific financial hardships, the IRS allows early withdrawals without penalties. These hardships include medical expenses, buying a first home, education expenses, and even adoption-related costs. Remember, though, you’ll still owe taxes on the amount withdrawn, so make sure to understand the requirements for each hardship withdrawal.
Borrowing from Your 401(k)
If your plan permits it, taking a 401(k) loan might be a better choice than an early withdrawal. With a loan, you’re borrowing against your own assets and committing to pay it back, helping preserve your retirement savings.
Personal Loan
For short-term financial needs, securing a personal loan might be a viable solution. It’s worth exploring this option before tapping into your retirement accounts.
Time Stamp: Use the Rule of 55 Carefully
While the rule of 55 opens up possibilities for early retirement, it’s essential to think carefully before taking action. These funds can be a lifeline if you retire early or lose your job. However, if you find alternative sources of income or secure another job, it’s wise to refrain from tapping into retirement accounts prematurely.
Frequently Asked Questions (FAQs)
When was the rule of 55 enacted?
The rule of 55 was enacted in 1988 as part of the Technical and Miscellaneous Revenue Act. This act made amendments to the tax code of 1968.
How much should I have in my 401(k) at the age of 55?
The ideal amount in your 401(k) at age 55 depends on several factors, such as your retirement plans and lifestyle expectations. As a rule of thumb, Fidelity Investments suggests having around six times your annual salary in your 401(k) by age 50 and eight times by age 60.
Is the rule of 55 the same as rule 72(t)?
The rule of 55 and rule 72(t) have some similarities, but they also have crucial differences. Rule 72(t) allows you to make penalty-free withdrawals from a 401(k), 403(b), or IRA by using substantially equal periodic payments (SEPPs). However, unlike rule 72(t), the rule of 55 does not apply to IRAs. The rule of 55 is more flexible, allowing you to determine when to withdraw funds from your workplace plans.
Remember, the rule of 55 can be a valuable tool in your retirement planning arsenal. However, it’s crucial to weigh the pros and cons carefully, considering your individual circumstances. To explore more personal finance tips and tricks, visit Personal Finances Blog.