Many of my clients are lifelong excellent savers and rule-followers. They do what’s suggested and keep doing it.
For that reason, many of my clients have a LOT of tax-deferred money set aside that can’t be touched until age 59.5 (there are exceptions, but they are a hassle).
This is a bummer: because they have saved so well, they can often retire earlier than that.
But fear not, fair savers. There is a loophole that is often forgotten that can be your knight in shining armor. The Rule of 55.
The Rule of 55 may allow you to take money from a 401(k) without paying the extra 10% tax if you leave your job during or after the calendar year in which you turn 55. You don’t actually have to be 55 on your last day of work. If you turn 55 anytime during that calendar year, you may qualify.
For example, suppose Nebuchadnezzar turns 55 in November. He decides to retire from his job in June of that same year. Nebuchadnezzar may be able to withdraw money from that employer’s 401(k) without paying the additional 10% early-withdrawal tax—even though he was only 54 when he left the company.
There is a catch
The rule only applies to the retirement plan connected to the employer you are leaving. It does not apply to withdrawals from an IRA.
That distinction can be important.
Suppose Methuselah leaves his job at age 52 and keeps his old 401(k). At 55, he decides he wants to start taking money from it. Unfortunately, simply reaching age 55 doesn’t make Methuselah eligible. Because he left that employer before the calendar year in which he turned 55, the Rule of 55 doesn’t apply to that plan. If Methuselah takes money out before 59½, he may owe the additional 10% tax unless another exception applies.
Also remember that “penalty-free” doesn’t mean tax-free. You still owe the income taxes on tax-deferred account withdrawals.
The Rule of 55 can be especially useful for someone who wants to retire—or simply leave a job—a few years before age 59½. But before moving money from a 401(k) into an IRA or taking a large withdrawal, check the rules carefully. A decision that seems small could affect your ability to use this valuable exception.
