The IRS has a rule called the Rule of 55 that allows people over the age of 55 to take money out of their 401(k) or 403(b) (b) accounts without incurring a tax penalty.
The Rule of 55: Definition and Application
If you have a 401(k), you may be aware that there is typically a 10% penalty for withdrawing any funds before reaching the age of 59 1/2. One exception to this Rule applies to those who are not yet retired and are between 55 and 59 1/2 years old. Assume you're 57 years old and have been laid off from your job. You may need to use your 401(k) funds now that you don't have any income from work. If you were under the age of 55, you would have to pay the penalty to do so. However, under the Rule of 55, you can withdraw from your retirement savings penalty-free since distributions were made to you after you left your employer's service and after you reached the age of 55.The Rule of 55 in Action
The 55-year Rule governs when and how you can access your retirement savings. If you are 55 to 59 1/2 years old and are laid off, fired, or quit your job, the IRS rule of 55 allows you to withdraw money from your 401(k) or 403(b) plan without penalty. It applies to employees who leave their jobs at any time during or after their 55th birthday year. There is a small catch. The Rule of 55 is only applicable to your current 401(k) or 403(b) assets (b), which means the one you invested in while working at the job you're leaving when you're 55 or older. The Rule does not apply to previous employer retirement plans, such as 401(k) or 403(b) (b). To begin withdrawing money from those accounts without incurring the 10% penalty, follow the steps below. You would have to wait until you were 59 1/2 years old. If you know, you'll be leaving your job, and there's a plan you can follow. You can gain penalty-free access to former employer plans if you roll them into your current 401(k) or 403(b) (b). After that, you can leave your current job before the age of 59 1/2 and withdraw the funds using the Rule of 55. Individual retirement accounts are also exempt from the 55-year Rule (IRAs). You would not be eligible for a penalty-free early withdrawal if you transferred assets into a rollover IRA after leaving your job.Alternatives to the 55th Rule
There are other options besides the Rule of 55 to withdraw penalty-free from a retirement plan. If you quit your job before you're 59 1/2 years old, you have another option for withdrawing funds from 401(k), 403(b), and even IRA retirement accounts. The exemption is known as the Substantially Equal Periodic Payment (SEPP) or an IRS Section 72(t) distribution. A SEPP plan has a unique twist. You begin by calculating your life expectancy. Then, for five years in a row, calculate five similar-sized payments from a retirement plan before the age of 59 1/2. What distinguishes these distributions is that they can occur at any age—the same age threshold does not constrain them as the Rule of 55.Should You Accept One of the Distributions?
If you need to retire before the age of 59 1/2, The ability to withdraw funds early can be a valuable safety net. If you can look for another job, a part-time job, or work as an advisor while you wait, do so. Allowing the money to grow tax-free until you are in your 60s might make more sense. Taking funds early may reduce the long-term value of your portfolio, especially if your first years of retirement are bearish for the market. Warning: If you expect to live a long life, early distributions may jeopardize your future income. Make your portfolio timing decisions with caution. You may be able to save money by taking taxable retirement plan distributions in the year when your tax liability is lower. Withdrawing money out of your retirement account during a higher-tax year, on the other hand, may cause unnecessary tax complications. Consult a tax professional, a financial planner, or the administrator of your retirement plan to develop a withdrawal strategy that will serve you well over time.Key Points
- You may be able to take money out of your 401(k) or 403(b) account without incurring a tax penalty if you are 55 or older.
- If you retire before the age of 59 1/2, you can take advantage of the Substantially Equal Periodic Payment (SEPP) exemption, also known as an IRS Section 72(t) distribution.
- If you can wait until age 59 1/2 to retire, It might be best to continue to work for a few more years so that your money can grow.
