The Rule of 55: What it is and How Can It Help You Fund Your Early Retirement Dreams?

Step By Step Financial |

You may have heard of the Rule of 55 before. It's a simple strategy that can help you fund your early retirement dreams, even if you still need to save up money.

When you take money out of your retirement account before you turn 59.5, the IRS will usually charge you a penalty of 10% plus the regular taxes you'll owe. However, there are exceptions:

  • There's no penalty if you're over age 59.5 and taking distributions from an IRA or 401(k).
  • Nor is there a penalty if you take advantage of the Rule of 55.

Understanding Your Tax-Advantaged Accounts

There are two types of tax-advantaged accounts: IRAs and 401(k)s. An IRA stands for Individual Retirement Account, which allows you to set aside money on a pre-tax basis. That means when you contribute money to an IRA, you will only owe income taxes on those funds once you withdraw them in retirement. And as a bonus, these contributions don't count toward your taxable income for the year, either.

A 401(k) is another type of retirement plan through which employees can save pre-tax earnings with their employer. At the end of each year, any money contributed will get deducted from your taxable income on Form 1040, meaning less money owed in taxes at tax time. 

You can also choose to contribute to both. For example, you might have a 401(k) through your employer and an IRA with another financial institution. 

If your income falls below these thresholds, consider setting up a Roth IRA. Roth accounts allow for post-tax contributions (meaning no deductions from taxable income). 

While a Roth IRA is similar to a 401(k), there are some key differences. For example, contributions to a Roth IRA are tax deductible. When you contribute to the plan, you won't get any immediate tax breaks like with other types of retirement savings. But, when you retire and start taking money out of the account, it will be taxed at your standard income tax rate. This is different from traditional IRAs, which don't tax earnings. 

Typically, you must wait until 59.5 to start taking distributions. Withdrawing funds early could trigger a 10% penalty on top of your income tax on the distribution. However, if you leave your job early, you might have a legal workaround for that penalty. 

What's The Rule of 55?

The Rule of 55 allows you to withdraw funds from your 401(k) without penalty if you're over the age of 55 and have left your job or become self-employed. This is not available for IRAs, so if you have an IRA, it's best to convert it into a Roth IRA instead.

The benefit of this conversion is future tax savings. With Roth IRAs, your contributions and earnings grow tax-free even though there is no initial tax advantage. Which is to once you pay taxes on the money you’re converting into a Roth IRA, you’re done paying taxes (as long as you take qualified distributions.)

With the Rule of 55, workers can get money from their employer-sponsored retirement plan before the normal qualifying age of 59.5 without paying the penalty. 

Of course, like anything related to taxes, it's more complicated. The Rule of 55 only applies to employer-sponsored accounts like 401(k)s. IRAs don't have the same Rule (this gets into IRS rule 72(t)). So if you transfer your old 401(k) into an IRA, you can't take advantage of this strategy. 

In addition, you have to make the withdrawals the year you turn 55 or later. And you're only eligible if you leave your job the year you turn 55 or later.

Also, you can only withdraw 401(k) funds from your most recent employer. If you have a few scattered around, you can't also tap those. If you think you might take advantage of the Rule 55, it would be a good idea to consolidate those accounts now. 

One more thing—you can't make the withdrawals until after you leave your employer, either.

The good news is that the Rule of 55 applies to many situations, like losing a job, retiring early, or changing careers. 

Plus, if you work in public safety, you can access this Rule when you turn 50—5 years earlier!

Not only that, but you can still withdraw from your previous employer's 401(k) even if you get a new job later.

How To Strategically Use 401k Income In The Bridge Period 

The bridging period refers to when you retire or leave your job and when retirement benefits like Social Security, pensions, and retirement plan withdrawals kick in. 

If you're making 401(k) withdrawals via the Rule of 55, you should be mindful that the distributions you take are taxable, so make sure not to take too much out at once. 

However, much of your retirement nest egg is likely in tax-sheltered accounts, so make sure you have a solid plan to generate enough income for yourself, and your family, before those additional benefits start paying out. 

Learn More About Financing Your Early Retirement

The Rule of 55 can help you make the most of your tax-advantaged retirement accounts. But before you take advantage of this Rule, it's important to understand its place within your unique financial plan. If you want to discuss your retirement options, schedule a call with us today.