Rule of 55
What is Rule of 55?
To be precise, it is a strategy that enables you to start withdrawing money from 401(k) funds without the 10% tax penalty after attaining age 55.
At this age, one has reached the mandatory retirement age as per IRS regulations and can take out any amount they wish with no penalty attached whatsoever.
Take note that only the 10% penalty is waived here. The distributions, like any other withdrawals from 401k accounts, will still be subject to income tax.
Also, the rule of 55 only applies to present employers of plan holders. That means if you have 401k plans from previous employers, you will not be entitled to a penalty-free withdrawal before reaching the age of 59 1/2 years old.
To access those funds from previous employers, it would be wise to have those funds transferred to your current 401(k) plans before any withdrawal is made using the rule of 55.
How Does the Rule of 55 Work?
You must first attain age 55 years before you withdraw funds from your 401k plan.
Once you reach that mark and you get laid off, fired, or you just want to quit your job, the 10% tax penalty will be lifted off your withdrawals from your 401k plans per the IRS leeway.
It is important to note that the rule of 55 does not apply to all types of retirement accounts like IRAs.
Timing It Right
As mentioned, distributions from 401k plans within the age of 55 to 59 are not totally tax-free since the same will still be subject to income tax.
To time your withdrawal right, it would be best to do them when you have less taxable income to declare for the year.
For example, if you were employed for the most part of a particular year, you will have a high income, too. If in the same year, you made a withdrawal from your 401k account using the rule of 55, it will still not be very beneficial for you.
This is because the summation of your taxable income for the year may actually move you to a higher marginal tax bracket. Thus, it will cause your income tax for the year to blow up.
A workaround for this scenario would be to delay your withdrawal from the 401k plan for the following year.
Other Strategies for Early Retirement
The rule of 55 is not the only strategy you can employ to pull off early retirement.
The SEPP plan, which stands for Substantially Equal Periodic Payment, is another strategy to consider for a lesser tax fee during early retirement.
The Bottom Line
The rule of 55 is a critical strategy to consider when planning for early retirement. For those wishing to retire as soon as possible, the rule of 55 will help you do the trick.
However, don’t make the mistake of thinking that this strategy has no catches and drawbacks because it enables one to take out money without having to pay any penalty attached.
It is helpful to carefully study the benefits and drawbacks of this strategy before actually employing it. Speaking to a financial advisor will help you weigh things more thoroughly.
Disclaimer: The above references an opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.