Retiring Early With The Rule of 55: Avoid This Common Surprise
As a former adviser at one of the nation's largest 401k plan providers, I’ve encountered thousands of recent retirees who are often caught off guard by one specific plan rule regarding their 401k. This rule can significantly impact their retirement strategy, especially for those considering early retirement.
In this post, I'm going to explain a crucial aspect of 401k and 403b plans that can be a surprise to many, particularly for those retiring early and planning to use the Rule of 55.
Here's the YouTube video if you prefer to watch instead of read:
What is the Rule of 55?
The Rule of 55 is an IRS regulation that allows individuals who leave their job during or after the year they turn 55 to withdraw money from their 401k or 403b without incurring the typical 10% early withdrawal penalty. Normally, withdrawals from retirement accounts like IRAs before age 59½ would be subject to this penalty. Here’s a breakdown of what you need to know about the Rule of 55:
Eligibility: This rule applies only if you leave your job during the year you turn 55 or later.
Applicable Accounts: The rule is valid for 401k or 403b plans, not IRAs.
Penalty-Free Withdrawals: You can withdraw funds without the 10% early withdrawal penalty, but income taxes still apply.
Key Caveats of the Rule of 55
While the Rule of 55 offers a way to access your retirement funds penalty-free, there are a few important conditions to keep in mind:
Current Employer’s Plan Only:
The Rule of 55 applies only to the 401k plan of the employer you work for during the year you turn 55 or later.
It does not apply to 401k plans from previous employers if you separated before the year you turned 55.
Income Taxes Still Apply:
Although you avoid the 10% early withdrawal penalty, you still owe income taxes on any pre-tax dollars withdrawn.
Direct Withdrawals Required:
To qualify, the withdrawal must come directly from the 401k plan.
Rolling over funds to an IRA and then withdrawing them will not qualify for the Rule of 55 and will attract the 10% penalty, with some exceptions.
I’ve encountered thousands of recent retirees who are often caught off guard by one specific plan rule regarding their 401k.
The Big Surprise: [No] Partial Withdrawals
A significant issue many retirees face is that their employer’s 401k plan may not allow partial withdrawals after they separate from service. This can be a major obstacle for those planning to use the Rule of 55.
From my experience, I would estimate that around 75% of 401k plans do not permit partial withdrawals after employment ends. This varies by employer, but it’s crucial to check your specific plan's rules.
Potential Scenarios and Solutions
Let’s consider a common scenario to understand the implications: Scenario:
You’ve worked hard and saved diligently for 30 years and decide to retire at 55.
You have accumulated $1.5 million in your 401k.
You need $30,000 annually to cover your living expenses.
If your plan does not allow partial withdrawals, you would be forced to withdraw the entire $1.5 million at once, which is the last thing you'd want to do because of the tax implications. Here are some solutions to this dilemma:
1. Lump Sum Withdrawal with Split Transactions
Strategy: Take a portion as a withdrawal and the rest as a rollover to an IRA.
Strategy: Withdraw an amount covering multiple years of expenses and roll over the rest.
Example:
Withdraw $150,000 to cover five years of expenses.
Roll over the remaining $1.35 million.
Considerations: Higher tax rate due to a larger single-year withdrawal.
3. 72(t) Distribution
Strategy: Use a 72(t) distribution to set up substantially equal periodic payments from your IRA.
Example: Calculate a fixed amount to withdraw penalty-free until you turn 59½ or for five years, whichever is longer.
Considerations: Once set up, you must continue the withdrawals without modification to avoid penalties.
Additional Considerations
Disability: If you are disabled, you can withdraw funds from your IRA penalty-free without needing a 72(t) distribution.
Plan Ahead: Review your 401k plan’s summary plan description or contact HR to understand the specific rules and options available to you.
Recap and Final Thoughts
If you’re planning to retire early and utilize the Rule of 55, it’s essential to understand your plan’s specific rules and prepare accordingly. Here’s a quick recap:
The Rule of 55 allows penalty-free withdrawals from your current employer’s 401k or 403b if you leave your job in the year you turn 55 or later.
Income taxes still apply to withdrawals.
Many plans do not permit partial withdrawals, necessitating careful planning.
To ensure a smooth transition into retirement, consider building up a separate savings account, such as a taxable brokerage account, to access funds without complications during the early retirement years. Alternatively, familiarize yourself with strategies like the 72(t) distribution for penalty-free IRA withdrawals.
Jake is a CFP Professional with a focus on planning for both traditional and early retirement. He’s a Florida native, growing up in Fort Lauderdale and now residing in Jacksonville with his husband Chris and their 120-lb “puppy” Barli. Jake enjoys cooking (favorite cuisine to make is Thai), traveling, and spending time with friends and family as much as possible.
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