Retiring Early? Know the Rule of 55
By Kaitlin Nicholis, CFP®
If you want to, or have to, retire before the age of 59 ½, it is especially important to have a financial plan in place for how you will fund your retirement. Most commonly, the majority of retirement savings are in qualified retirement accounts, like a 401(k) or 403(b). Once you leave employment, you may think the best course of action is to rollover your 401(k) or 403(b) to an IRA. However, if you start to withdraw funds from an IRA before the age of 59 ½, not only will you have to pay income tax on the withdrawal of any pre-tax money, you will also owe a 10% additional tax penalty to the IRS. If you keep your 401(k) or 403(b) with your most recent employer, the Rule of 55 may help you avoid that 10% penalty.
The Rule of 55 states that if you leave your job in or after the year you reach age 55, you can avoid paying the additional 10% tax penalty on withdrawals from your 401(k) or 403(b). If you are a qualified public safety employee on the federal, state or local level, like a police officer or EMT, you may be able to avoid the penalty if you leave your job in or after the year you reach age 50. Not all employers support these early withdrawals, so it is best practice to first review the plan rules with your retirement plan provider or record-keeper.
Also to note is that the Rule of 55 only applies to your most recent employer’s retirement plan. Therefore, if you have multiple retirement accounts with past employers, it may make sense to rollover those accounts into your current 401(k) or 403(b) before you leave your job. As a result, you will have a larger balance to draw from to fund those early years of retirement without paying a penalty. Later on, if you decide to return to work, either part-time or full-time, you can continue to take penalty free withdrawals as long as they are from the same account from which you began withdrawing.
Other circumstances may allow you to avoid the 10% tax penalty on withdrawals before age 59 ½, such as permanent disability, medical expenses that exceed 7.5% of your adjusted gross income, qualified disaster distributions, divorce, etc. You may also be able to take Substantially Equal Periodic Payments under IRS Rule 72(t). The Periodic Payment is a specific amount determined by formulas set by the IRS that you must withdraw each year for a period of 5 years or until you turn age 59 ½, whichever is later. However, this could deplete your retirement savings faster than you may need or want to. Therefore, if it applies to you, the Rule of 55 gives you the most flexibility to fund your early retirement years. Before taking the leap into early retirement, talk with your advisor about your options and make a plan that best suits your unique situation.
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