The rule of 55 is a provision in the Internal Revenue Code that allows workers to withdraw money from their employer-sponsored retirement plan without a penalty once they reach age 55. Distributions are still taxable as income but there’s no additional 10% early withdrawal penalty.
The IRS rule of 55 applies to 401(k) and 403(b) plans. If you have either of these types of retirement accounts through your employer, it’s important to understand how this rule works when taking retirement plan distributions.
What Is the Rule of 55?
The rule of 55 is an exception to standard IRS withdrawal rules for qualified workplace plans, including 401k and 403b plans. Under normal circumstances, you can’t withdraw money from these plans before age 59 ½ without paying a 10% early withdrawal penalty. This penalty is only waived for certain allowed exceptions, of which the rule of 55 is one.
Specifically, the rule of 55 applies to “distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55,” per the IRS. It doesn’t matter whether you quit, get laid off or retired — you can still withdraw money from your plan penalty-free. If you’re a qualified public safety employee, this exception kicks in at age 50 instead of 55.
How Does the Rule of 55 Work?
The rule of 55 for 401k and 403b plans allows workers to access money in their retirement plans without a 10% early withdrawal penalty. This rule applies to current workplace retirement plans only. You can’t use it to take money from a 401k or 401b you had with a previous employer penalty-free unless you first roll over those account balances into your current plan before separating from service.
This rule doesn’t apply to individual retirement accounts (IRA) either. So, you can’t use the rule of 55 to tap into an IRA before age 59 ½ without a tax penalty. There are, however, some exclusions that might allow you to do so. For example, you could take money penalty-free from an IRA if you’re using it for the purchase of a first home.
Rule of 55 Requirements
To qualify for a rule of 55 401k or 403b withdrawal, you’ll need to:
• Be age 55 or older
• Separate from your employer at age 55 or older
• Leave the money in your employer’s plan (rule of 55 benefits are lost if you roll funds over to an IRA)
You also need to have a 401k or 403b plan that allows for rule of 55 withdrawals. If your plan doesn’t permit early withdrawals before age 59 ½ , then you won’t be able to take advantage of this rule.
Also keep in mind that IRS rules require a 20% tax withholding on early withdrawals from a 401k or similar plan. This applies even if you plan to roll the money over later to another qualified plan or IRA. So you’ll need to consider how that withholding will affect what you receive from the plan and how much you may still owe in taxes on your 401k later when reporting the distribution on your return.
Should You Use the Rule of 55?
The IRS rule of 55 is designed to benefit people who may need or want to withdraw money from their retirement plan early for a variety of reasons. For example, you might consider using this rule if you:
• Decide to retire early and need your 401k to close the income gap until you’re eligible for Social Security benefits
• Are taking time away from work to act as a caregiver for a spouse or family member and need money from your retirement plan to cover basic living expenses
• Want to take some of the money in your 401k early to help minimize required minimum distributions (RMDs) later
In those scenarios, it could make sense to apply the rule of 55 in order to access your retirement savings penalty-free. On the other hand, there are some situations where you may be better off letting the money in your employer’s plan continue to grow.
For instance, if your employer’s plan requires you to take a lump sum payment, this could push you into a substantially higher tax bracket. Having to pay taxes on all of the money at once could diminish your account balance more so than spreading out distributions — and the associated tax liability — over a longer period of time.
You may also reconsider taking money from your 401k early if you still plan to work in some capacity. If you have income from a new full-time job or part-time job, for instance, you may not need to withdraw funds from your 401k at all. But if you change your mind later and decide to return to work, you can continue to take withdrawals from the same retirement plan penalty-free.
Other Ways to Withdraw From a 401k Penalty-Free
Aside from the rule of 55, there are other exceptions that could allow you to take money from your 401k penalty-free. The IRS allows you to do so if you:
• Reach age 59 ½
• Pass away (for distributions made to your plan beneficiary)
• Become totally and permanently disabled
• Need the money to pay for unreimbursed medical expenses exceeding 10% of your adjusted gross income (AGI)
• Need the money to pay health insurance premiums while unemployed
• Are a qualified reservist called to active duty
You can also avoid the 10% early withdrawal penalty by taking a series of substantially equal periodic payments. This IRS rule allows you to sidestep the penalty if you agree to take a series of equal payments based on your life expectancy. You must separate from service with the employer that maintains your 401k in order to be eligible under this rule. Additionally, you must commit to taking the payment amount that’s required by the IRS for a minimum of five years or until you reach age 59 ½, whichever occurs first.
A 401k loan might be another option for withdrawing money from your retirement account without a tax penalty. You might consider this if you’re not planning to retire but need to take money from your retirement plan.
With a 401k loan, you’ll have to pay the money back with interest. Your employer may stop you from making new contributions to the plan until the loan is repaid, generally over a five-year term. If you leave your job where you have your 401k before the loan is repaid, any remaining amount becomes payable in full. If you can’t pay the loan off, the whole amount is treated as a taxable distribution and the 10% early withdrawal penalty also may apply if you’re under age 59 ½.
Early retirement may be one of your financial goals, and achieving it requires some planning. Maxing out your 401k or 403b can help you save the money you’ll need to retire early, and you may be able to access the funds early with the rule of 55.
You may also consider investing in an IRA or a taxable brokerage account to save for retirement. A brokerage account doesn’t have age restrictions, so there are no penalties for early withdrawals before age 59 ½. You’ll have to pay capital gains tax on any profits realized from selling investments, but you can allow the balances in your 401k or IRA to continue to grow on a tax-advantaged basis.
The information provided is not meant to provide investment or financial advice. Also, past performance is no guarantee of future results.
Investment decisions should be based on an individual’s specific financial needs, goals, and risk profile. SoFi can’t guarantee future financial performance. Advisory services offered through SoFi Wealth, LLC. SoFi Securities, LLC, member FINRA / SIPC . SoFi Invest refers to the three investment and trading platforms operated by Social Finance, Inc. and its affiliates (described below). Individual customer accounts may be subject to the terms applicable to one or more of the platforms below.
1) Automated Investing—The Automated Investing platform is owned by SoFi Wealth LLC, an SEC registered investment advisor (“Sofi Wealth“). Brokerage services are provided to SoFi Wealth LLC by SoFi Securities LLC, an affiliated SEC registered broker dealer and member FINRA/SIPC, (“Sofi Securities).
2) Active Investing—The Active Investing platform is owned by SoFi Securities LLC. Clearing and custody of all securities are provided by APEX Clearing Corporation.
3) Cryptocurrency is offered by SoFi Digital Assets, LLC, a FinCEN registered Money Service Business.
For additional disclosures related to the SoFi Invest platforms described above, including state licensure of Sofi Digital Assets, LLC, please visit www.sofi.com/legal. Neither the Investment Advisor Representatives of SoFi Wealth, nor the Registered Representatives of SoFi Securities are compensated for the sale of any product or service sold through any SoFi Invest platform. Information related to lending products contained herein should not be construed as an offer or prequalification for any loan product offered by SoFi Bank, N.A.
Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
Photo credit: iStock/bagi1998