Rule of 55 for 401(k) Withdrawal

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I had never heard of the Rule of 55 until a couple of months ago when a Certified Financial Planner (Jim Blankenship, CFP) mentioned the possibility in a discussion forum I frequent. I'm not an expert on this rule (or any IRS rule) but here's what I've learned about this penalty-free method of taking a 401(k) withdrawal.

 

Here's how this conversation got started: a participant posed the question about what to do with a 401(k) account with a soon-to-be former employer when making a job change. I mentioned the the three main ways (I knew of) to handle it:

  1. roll the 401(k) with a former employer to a new employer;
  2. keep the 401(k) with the former employer while you decide on the best move (because making a decision about a retirement account in the midst of relocating to a new city and starting a new job may require more mental bandwidth than you can handle);
  3. roll the 401(k) over to an IRA.

I omitted the possibility of taking a distribution now because that way horrifies me for many reasons including the tax penalty on early 401(k) withdrawals.

What ensued in the discussion forum was a debate about the merits of 401(k)s compared to IRAs. Many insisted that IRAs were always better than 401(k)s because of fees associated with employer-sponsored plans. A few others, like me, defended the 401(k) because of its special features and the general caveat that the right move depends on the particulars of an individual's unique circumstances.

This argument is similar to the one regarding student loans: you may not want to consolidate, refinance, and thus reclassify federal loans to a private status because you'll lose special benefits, such as the ability to defer payments while you're unemployed — even though there's a possibility that you'll get a better rate. The idea here is to look at the obvious comparisons (investment fees and interest rates, for example) and consider features that could save you money under certain circumstances.

For example, keeping money in 401(k) rather than a traditional IRA may be advantageous taxwise if you happen to do a Roth IRA conversion. Schwab has a calculator to help you see the impact of non-Roth IRAs in the conversion.

For me, the surprise benefit uncovered in the forum discussion was the Rule of 55. In general, this rule allows 401(k) accountholders to begin penalty-free withdrawals at the age of 55 under certain circumstances. Based on my research and understanding, these circumstances include:

  • you are displaced from an employer in the year you turn 55 or older
  • money you are withdrawing comes from a 401(k) must be associated with an employer from which you were displaced after becoming 55 or older

Mike Piper, CPA and author of the Oblivious Investor, explains this rule and references the IRS tax code that mentions this exception to the 10% penalty in a blog post. He also clarifies that you can't quit at age 50 and expect to get access to your money free of tax penalties at age 55; you've got to work for the employer with the 401(k) until you've come of age at 55 years old (or turn 55 in the year in which you become separated from your employer).

You can find an explanation from the IRS on this topic here.

Note that you'll still have to pay regular income taxes on withdrawals. In addition, your state's department of revenue may have different rules about early withdrawals than the IRS.

Further, I'll mention that an article in The Motley Fool states that your 401(k) plan may not allow these types of withdrawals. So, even though the IRS allows the withdrawal penalty-free doesn't mean that you'll automatically gain access to your money. You'll need to check with the plan administrator and plan documents to be sure.

The Oblivious Investor and The Motley Fool seem to disagree on one point about the Rule of 55. Oblivious argues that you can access money from any 401(k) plan in which you were displaced from the sponsoring employer at 55 or older while the Fool says that you'll only be able to get money from the most recent employer.

This nuance in interpretation leads back to the original discussion. One option for dealing with an old 401(k) is to move money to the new 401(k), from which you may be able to withdraw money when you turn 55.

The main point is that you may have this early distribution option with a 401(k) — or a similar ERISA-qualified, employer-established defined contribution plan such as a 403(b) as Jim explains in his article on this topic — but not with an IRA. So, if you plan to retire early or earlier than 59.5 years, then you might consider keeping money inside the 401(k) plan rather than doing an IRA rollover. To decide on the approach that's right for you and understand how the rule of 55 might apply to your situation, consider consulting with a CFP and/or tax advisor.

7 responses to “Rule of 55 for 401(k) Withdrawal

    1. There should be an administrator associated with your 401(k) plan. This person or group should be able to answer questions and help you complete transactions.

  1. I have a 401 k which I owe the amount of 9,600 from 24,000, but unable to pay back my loan for personal reason and now I am laid off my job after 13 years. I know if i withdrew the remaining money i am subject to regular taxes and penalties. Is there an exception from paying the penalty if i am 57 and laid off.

    1. Your 401(k) plan administrator and tax professional (and/or the IRS) may be able to help you determine how the Rule of 55 might apply to your situation.

  2. Just lost my job and I want to take $5000 out of my 401 to take a class and pay for books what penalty do I have to pay, I am over 55 also I rolled my 401k into an IRA ,

  3. I will be 55 this year and my job has gotten to stressful and it is starting to affect my health. With. That being said I am thinking of retiring at the end of the year. I have had this employer sponsored 401k for 14 years. Would I qualify for the 55 rule and be able to draw my funds without penalty. I am in Louisiana.

    1. You’d likely need to talk to your tax professional and 401(k) plan administrator to determine how the Rule of 55 might apply to your situation.

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