Retirement Hack - Rule of 55
“If you change jobs or retire between the ages of 55 and 59 1/2, learn how to pull money out of your 401(k) penalty-free by utilizing the lesser-known Rule of 55.”
Rule of 55
For those of you entering your 50s, I wanted to take a moment to let you know about an intriguing and potentially beneficial strategy I recently took advantage of, which is known as the Rule of 55. As you may already be aware, if you withdraw money from your retirement accounts before reaching the age of 59 ½, you will typically face an early withdrawal penalty of 10%, in addition to the possibility of incurring income taxes on that amount. Due to this penalty, most individuals choose not to make withdrawals ahead of time. However, there are some exceptions to this rule, which I have detailed below, one of the more intriguing and lesser known being the Rule of 55.
How does it work?
In the year you turn 55 or later if you leave your job, you can withdraw money from your 401(k) or 403(b) without a penalty, known as the Rule of 55. It's important to consider this rule in your financial planning if you have an employer-sponsored plan. Check your Summary Plan Description to see if you're eligible for this strategy, some plans may not permit it.
If it is permitted, you can still take money from your 401(k), even if you start a new job. Certain jobs, like police and firefighters, allow access to retirement funds starting at age 50. For other plans like IRAs, you must be 59½ to withdraw without penalties. If you transfer money from a 401(k) to an IRA, you will lose the Rule of 55 benefit. This rule only applies to the employer-sponsored retirement plan with your most recent employer.
If you have a Rollover IRA and will soon leave your job, and your retirement plan allows the Rule of 55, you might want to roll your IRA into your 401(k) before you leave. This could give you more funds for withdrawals.
Why Consider a Rule of 55 Withdrawal?
As a financial planner, I usually don’t suggest taking money from retirement accounts early, but there are some exceptions. Let’s look at a couple.
You are unemployed for a good amount of time
You are starting your own business
You have large retirement accounts and want to remove some funds now as you may currently be in a lower tax bracket
If your plan document denies the rule of 55, what should you do?
Let’s review an example - Brian recently turned 55 the same year he left his employer and has $250,000 in his most recent employer’s 401(k) plan and wants to withdraw $50,000 to start a business and for other expenses, but his plan doesn't allow the rule of 55 withdrawal.
A retirement hack to solve this problem is to roll over $200,000 to an IRA and take the remaining $50,000 as a direct distribution. Consult with your Tax Advisor before implementing any tax strategy as your individual situation can vary.
Brian withdrew $50,000 from his retirement plan without a 10% penalty. This was a good decision since his income is lower this year, resulting in lower taxes on the withdrawal. His financial plan indicates he may face a high tax rate later in retirement due to large required minimum distributions from his retirement accounts. Therefore, any actions to reduce his tax burden now will help him long-term.
Nerdy Detail:
Your 401k provider should fill in box 7 on Form 1099-R with code 2. Tax programs like TurboTax and the IRS recognize code 2 as meaning there is no penalty for early distribution. If the provider uses code 1 instead, you can still file Form 5329 Part I and claim a code 01 exception to avoid the penalty on line 2.
Exceptions to the 10% Penalty
Exception Details:
401(k) Loan allows you to borrow from your retirement savings, up to 50% or $50,000, whichever is lower. If 50% is less than $10,000, you can borrow $10,000. You must repay the loan, with interest, within 5 years unless it's for buying a primary home. Your plan may have limits on loans, and you might need your spouse's approval.
Birth or Adoption: You can withdraw up to $5,000 per child for qualified birth or adoption expenses.
Death or Disability: No 10% penalty if you are permanently disabled or if the account owner has died and you are a beneficiary.
Disaster Recovery: If you have an economic loss due to a federally declared disaster, you can withdraw up to $22,000.
Divorce: A QDRO (Qualified Domestic Relations Order) permits a 401(k) division in a divorce, allowing the "alternate payee" (usually an ex-spouse) to access retirement benefits without penalties or taxes. For IRAs, the divorce decree indicates how the IRA is divided and the amounts received.
Domestic abuse victim distribution: Victims of domestic abuse can withdraw $10,000 or 50% of their account, whichever is lower.
Education Costs: To cover qualified education costs. These include tuition, school fees, books, supplies, equipment, and disability services if needed. If the student is enrolled more than half-time, room and board costs are also included.
Emergency Personal Expense: Each person may withdraw up to $1,000, once every three years, for personal or family emergency expenses.
Emergency Savings Account: distributions from a pension-linked emergency savings account (made after 12/31/2023)
Health Insurance: To cover health insurance costs assuming:
You’re unemployed.
You’ve received unemployment compensation for at least 12 consecutive weeks.
You are paying health insurance premiums for yourself, your spouse, or your dependents.
Home Expense: You can use your IRA to buy, build, or improve a home for specific individuals who haven't owned a main home in the past two years, including yourself, your spouse, children, and parents. Funds must be used within 120 days, with a pre-tax lifetime limit of $10,000.
Long Term Care Insurance. Beginning in 2026, you can distribute the lesser of 10% of your vested retirement benefit or $2,500 to pay your or spouse’s long term care premiums without being subject to a 10% penalty for an early distribution.
Medical Expenses: You can avoid an early withdrawal penalty if you use the funds to pay unreimbursed medical expenses that are more than 7.5% of your adjusted gross income (AGI).
Military: Qualified military reservists called to active duty can make some withdrawals without penalties.
Rule of 55: covered above
Substantially Equal Periodic Payments (SEPP) (a.k.a. 72(t)): The IRC permits penalty-free withdrawals from qualified plans for those under 59½ via substantially equal payments (SEPP) based on life expectancy, usually after employer termination. Once established, no new contributions or non-SEPP withdrawals are allowed. Withdrawals can use RMD, fixed amortization, or fixed annuitization methods. Early retirees benefit since annual SEPP distributions must be maintained to avoid penalties, continuing for at least five years or until age 59½, whichever is later.
Prior Employer Qualified Plans
Some plan documents may not permit the exceptions mentioned. In some cases, transferring to an IRA might be advisable to access the earlier withdrawal options.
Withdrawals after age 59 1/2
Traditional IRA & Prior Employer Qualified Plans
At age 59 1/2, you can withdraw any amount from your IRA or former employer's plan without penalty, though federal and state taxes may apply.
Existing Employer’s Qualified Plan
Working after 59 ½ may restrict withdrawals until you leave your job and requires a specific number of years to fully vest for employer contributions.
In-Service Withdrawals: An in-service withdrawal lets employees take distributions from retirement plans, like 401(k)s, without leaving their company. It can be penalty-free after age 59½, or for specific needs such as buying a first home or facing hardship. Some plans allow withdrawals without these conditions. In 2019, about 70% of U.S. retirement plans offered in-service withdrawals under certain circumstances.
In-Service Rollovers: An in-service rollover allows transfer of funds from your employer's 401(k) to an IRA without changing jobs, providing access to more investments or lower fees while still employed.
Ville Wealth Management is a Registered Investment Adviser in the state of Ohio. Advisory services are only offered to clients or prospective clients where Ville Wealth Management and its representatives are properly registered or exempt from registration. “Likes” should not be considered a positive reflection of the investment advisory services offered by Ville Wealth Management. Brian Jaros is an investment adviser representative of Ville Wealth Management. The firm is a registered investment adviser and only conducts business in jurisdictions where it is properly registered, or is excluded or exempted from registration requirements. Registration as an investment adviser is not an endorsement of the firm by securities regulators and does not mean the adviser has achieved a specific level of skill or ability. The information presented on this post is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Comments should not be construed as an offer to buy or sell, or a solicitation of an offer to buy or sell the investments mentioned. A professional adviser should be consulted before implementing any of the strategies discussed. Investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's portfolio. All investment strategies can result in profit or loss.
