What Is the Rule of 55?

Understanding the IRS Rule for Taking 401k Distributions Starting at 55

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If you have a 401(k) plan, you probably already know that there's generally a 10 percent penalty for withdrawing funds before age 59 1/2.

There are exceptions to this early distribution rule, and one affects pre-retirees in particular. It's known as the Internal Revenue Service's Rule of 55. If you are age 55 or older, it's something you should know about. 

What Is the Rule of 55?

The IRS Rule of 55 let's an employee who is laid off, is fired or quits a job between the age of 55 and 59 1/2 pull money from their 401(k) or 403(b) plan without penalty.

 This applies to workers who leave their jobs anytime during or after the year of a 55th birthday. 

The Rule of 55 only applies to assets in your current 401(k) or 403(b)—the one you invest in at the job you are leaving at age 55 or older. If you have money in former 401(k) or 403(b), it is not eligible for the early withdrawal penalty exemption. You would have to wait until age 59 1/2 to begin withdrawing funds if you wanted to do so without paying a 10 percent penalty. 

This rule of 55 does not apply to individual retirement accounts (IRAs). If you were to move assets into a rollover IRA upon leaving a job, you would not be eligible for early withdrawal under the Rule of 55. 

What Is a Section 72(t) Distribution? 

There's another way to take out 401(k), 403(b) and even IRA retirement assets if you leave a job before the age of 59 1/2. It's known as the Substantially Equal Periodic Payment (SEPP) exemption, or IRS Section 72(t) distribution.

Using this type of distribution rule, you would start by calculating your life expectancy, and use that to calculate five substantially equal payments from a retirement plan for five years in a row before the age of 59 1/2. However, distributions may occur at any age, and are not bound by the same age 55 threshold as the Rule of 55.

 

Should You Take Either Distribution? 

The ability to take out money early is a great safety net for those who must retire before age 59 1/2. But if it's possible to hold off and find another job, part-time job or work as a consultant, it may make more sense to let the money continue to grow, tax-deferred, well into your sixties. Taking funds out early could decrease the long-term value of your portfolio. This is particularly true if your initial years of retirement are bad ones for the market. If you expect to live a long life, early distributions could put your future income at risk.

Consider carefully all the timing of all portfolio withdrawal decisions. Working with a tax advisor, a financial planner or retirement plan administrator to create a sustainable withdrawal strategy. 

Learn more in IRS Publication 575.