The Rule of 55 Explained – What Is the Rule of 55?

Because your 401(k) account is likely one of the most important assets you own, it is absolutely necessary to be familiar with the circumstances under which you might withdraw proceeds from it and the procedures involved. 

These accounts are designed to provide monetary support for your retirement, and after you reach the age of 59 and a half, you will no longer be subject to any penalties for drawing proceeds from them. Taking proceeds out of your 401(k) before that time will, in most situations, result in significant financial penalties: There is a 10% fee assessed for any premature payouts.

There are, nonetheless, a few exceptions to this rule, and if you desire or need to retire earlier than normal, one of these could be of assistance to you. 

The “Rule of 55” is a regulation of the Internal Revenue Service that enables you to make charges-free payouts from your 401(k) or 403(b) account once you reach the age of 55 or older. Continue reading to learn how it operates.

What Exactly Is The Rule of 55?

If you leave your present job in the year that you turn 55 or after that year, you are waived from paying the 10% premature payout charges that are linked with the 401(k) or 403(b) plan that your present employer offers. 

Those who are qualified to work in public safety can end their careers even earlier, at the age of 50. It makes no difference whether you resigned, were fired, or were laid off from your previous job.

The dividends do not enjoy a total exclusion from taxes: You are required to pay income tax on any proceeds that you take out of a typical 401(k) or 403(b) plan, just like everyone else. In this circumstance, the only tax charge that can be avoided is the 10% charge.

It is also important to keep in mind that companies are not required to permit premature payouts, and if they do permit premature payouts, they may stipulate that the entire quantity be withdrawn all at once in the form of a lump payment. Because of this, you may be subject to a higher rate of income tax.

This restriction applies only to active 401(k) and 403(b) plans, not to defunct plans of either type. The government does not permit you to withdraw proceeds from plans you had with a previous job charges-free before you reach the age of 59.5. 

Transferring such monies into your existing 401(k) or 403(b) plan is necessary if you wish to have access to that proceeds after reaching the age of 55, as the rule requires.

How Does the Rule of 55 Work?

Withdrawing from your retirement fund is governed by the ‘Rule of 55’, which sets a minimum age of 55 years. The IRS Rule of 55 states that if you are 55 or older and have been laid off, dismissed, or have decided to leave your work, you may access your 401(k) or 403(b) without incurring charges.

Employees who resign at any time during or after the year in which they turn 55 are eligible.

Retirement plans from former jobs, such as 401(k)s and 403(b)s, are waived from the requirement. To avoid the 10% premature payout charges, you’ll need to wait until you’re at least 59 1/2 years old to start tapping into those accounts.

If you’re sure you want to leave your work, there’s a plan you can follow. If you have a present 401(k) or 403(b) account, you can roll over retirement plans from previous employment without incurring any penalties. You can then use the Rule of 55 to withdraw the proceeds if you quit your employment before you turn 59 and 1/2.

Individual retirement accounts (IRAs) are likewise waived from the Rule of 55. When you leave your employment and put your proceeds in a rollover IRA, you won’t be able to access it early without paying charges.

How to Use the Rule of 55 for Early Retirement?

If you plan on retiring early, you may have to tap into your retirement savings before the age of 59 1/2.

If you retire before you qualify for Social Security, you’ll have to find other ways to cover your basic needs and possibly even more expensive items like health insurance.

The Rule of 55 suggests that you begin making payouts from your retirement accounts and other investments when you reach age 55 unless you have a large number of proceeds sitting in savings and checking accounts.

The following are the requirements that must be met before you can make any payouts from your account. They are as follows:

• At the end of the calendar year in which you turn 55, you are required to retire. If you work for the government, this drops down to age 50. The Rule of 55 doesn’t apply if you retire before age 55 and start drawing your proceeds.

• Withdrawals need you to stop working for the time being, but you will be able to go back to your old job in the future. Leaving the workforce isn’t necessarily permanent.

• If you want to use the Rule of 55 with your 401(k) or 403(b) account, you can only access the proceeds in your most recent account.

To avoid the 10% premature payout charges, the Rule of 55 may apply to you if you match all of the above criteria and are 55 years old or older.

Once you’ve established your eligibility with the plan administrator, you can begin making payouts. Nevertheless, you should carefully contemplate the timing of those payouts.

Can I Use the Rule of 55 and Continue Working?

If you take payouts before age 55, you are not required to retire early. The 401(k) premature payout charges can be avoided by continuing to take payouts from the same retirement account even if you return to work, whether part- or full-time.

You are free to accept a new position after starting charges-free payouts from your previous employer’s plan. You might also put proceeds into a workplace retirement plan through your new company.

Is the Rule of 55 Worth It?

It’s important to contemplate your own monetary condition while deciding whether or not to make premature payouts under the Rule of 55. 

To make the most of your early retirement years, you should be well-versed in your plan’s regulations, the quantity you would need to withdraw, and the anticipated yearly expenses. If you can answer those questions, you’ll have a far better idea of whether or not a premature payout is the best option for you.

Here are certain cases in which it’s highly recommended against making any premature payouts.

1. If doing so will cause your income tax rate to increase. You may be subject to a higher marginal tax rate if the quantity of your regular yearly income and the quantity withdrawn from your retirement account in the first year of the withdrawal puts you in a higher tax bracket.
   
2. For those situations where a lump sum is obligatory. An unexpectedly large withdrawal from your plan could leave you with regular income tax liabilities and cause you to take out more proceeds than you’d like. The option to receive these proceeds tax-free in retirement no longer exists.
   
3. In the event that your age is less than 55. If you plan to start making payouts from your retirement account before you turn 55, you should contemplate quitting your job before the year in which you will reach that age. Please be aware that doing so will result in the imposition of the 10% premature payout charges and is therefore not permitted.

Alternatives to the Rule of 55

Taking proceeds out of a retirement plan without paying taxes is possible in other approaches besides the “Rule of 55.” 

Leaving your employment before you reach age 59 1/2 does not mean you have to immediately start drawing proceeds from your 401(k), 403(b), or individual retirement account (IRA). This type of distribution is waived from taxation under IRS Section 72(t) and is also recognized as a Substantially Equal Periodic Payment (SEPP).

The twist in a SEPP plan is significant. One begins by making a rough calculation of your remaining lifespan. Then, use it to determine how much proceeds you may expect to get yearly from your retirement plan for the next five years before you turn 59 and a half. These dividends are distinct from the Rule of 55 in that they are not limited to a specific age range.

Bottom Line

If you are able to put off making payouts from your retirement account until you turn 59 and a half, you will avoid having to pay the additional 10% tax that the IRS assesses on those payouts. This may be a reasonable potential next step for you to take, nonetheless, if you are on a monetarily secure footing to retire sooner and would like to do so.

Nevertheless, the Rule of 55 may provide a temporary lifeline if you are forced to start payouts at age 55 because you cannot find gainful employment or are unable to establish a business or generate proceeds in any other way.