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What is the rule of 55 and how does it work?

The rule of 55 can benefit workers with an employer-sponsored retirement account such as a 401(k) who are looking to retire early or need access to the funds if they’ve lost their job near the end of their career. It can be a lifeline for those workers who need cash flow and don’t have other good alternatives.

Here’s how the rule of 55 works and whether you should consider it using it.

What is the rule of 55?

The rule of 55 is an IRS provision that allows workers who leave their job for any reason to start taking penalty-free distributions from their current employer’s retirement plan once they’ve reached age 55. It allows those looking to retire earlier than normal or those who need the cash flow a way to take distributions from their retirement plans sooner than is typically allowed.

Taking a distribution from a tax-qualified retirement plan, such as a 401(k), prior to age 59 1/2 is generally subject to a 10 percent early withdrawal tax penalty. However, the IRS rule of 55 may allow you to receive a distribution after reaching age 55 (and before age 59 1/2 ) without triggering the early penalty if your plan provides for such distributions.

Any distribution would still be subject to an income tax withholding rate of 20 percent, however. (If it turns out that 20 percent is more than you owe based on your total taxable income, you’ll get a refund after filing your yearly tax return.)

It’s important to note that the rule of 55 does not apply to all 401(k)s and is not available at all for traditional or Roth IRAs.

How to use the Rule of 55 to retire early

Many companies have retirement plans that allow employees to take advantage of the rule of 55, but your company may not offer the option.

“401(k) and 403(b) plans are not required to provide for rule of 55 withdrawals, so don’t be surprised if your plan does not allow this,” says Paul Porretta, a compensation & benefits attorney at Troutman Pepper, a law firm based in New York, NY.

“Many companies see the rule as an incentive for employees to resign in order to get a penalty-free distribution, with the unintended consequence of prematurely depleting their retirement savings,” he says.

Here are the conditions that must be met and other things to consider before taking a rule of 55 withdrawal.

  • Retirement plan offers them. Your company’s plan offers a 401(k) or 403(a) or (b) that allows rule of 55 withdrawals. Some plans prohibit withdrawals prior to age 59 1/2 or even 62.
  • Age 55 or older. You leave a position (voluntarily or involuntarily) in or after the year you turn 55 years old.
  • Money must remain in plan. You fully understand that your funds must be kept in the employer’s plan before withdrawing them and you can only withdraw from your current employer’s plan. If you roll them over to an IRA, you lose the rule of 55 tax protection.
  • Potential lost gains. You understand that taking early withdrawals means forfeiting any gains that you might otherwise have earned on your investments.
  • Reduce taxes. You can wait until the start of the next calendar year to begin rule of 55 withdrawals when your taxable income should be lower if you are not working.
  • Public safety worker. If you are a qualified public safety worker (police officer, firefighter, EMT, correctional officer or air traffic controller), you might be able to start 5 years early. Make sure you have a qualified plan that allows withdrawals in or after the year you turn 50 years old.

However, as with any financial decision, be sure to check with a trusted advisor or tax professional first to avoid any unforeseen consequences.

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