IRS Rule of 55

Rule of 55 IRS

Rule of 55 is an IRS regulation that allows individuals aged 55 or older to withdraw funds from old plans like 401ks or 403bs( and not an IRA) without accruing the customary 10% early penalty.

The Rule of 55 applies when:

You leave your current employment when you turn 55 or later

Leaving employment includes being fired, laid off, or you quit.

Public service workers g. police officers or air traffic controllers may qualify at age 50.

Funds are withdrawn only from the 401k account of the most recent employer.

Only withdrawal from the current account is allowed. Withdrawals from previous employer accounts are not penalty-free

Please note the rule does not apply to you leaving employment before attaining 55 years in that calendar year.

How the Rule of 55 affects early retirement

It’s worth noting that the only real advantage of the Rule of 55 is protecting you from the 10 percent penalty.

 However other desired and undesired effects may manifest in the form of;

• Being required to take a lump sum. This means you might be forced to take more money than you need.
• You might be pushed to a higher marginal tax bracket.
• Early retirement may lead to a higher cost of private health care before Medicare,
• Early retirement leads to the depletion of portfolio assets not to mention excess taxes.

Can I use the rule of 55 and still work

Workers over the age of 55 can still be in active employment and can withdraw funds from their 401k or 403b accounts without incurring penalties.

Also, Should you get laid off when above 55 years, you are allowed to take withdrawals from the 401k or 403b account that you left before attaining 55 years, however, the following conditions are applicable in this case;

• As long as it’s the same plan that you were a member when you quit at age 55—and
• The funds have not been rolled into another employer plan or IRA.

Rule of 55 401k

IRS does not mandate 401k plans to apply the Rule of 55.

Don’t be surprised if your 401k plan doesn’t cater to this. Most employer-sponsored plans see this as an incentive for employees to resign and access this penalty-free distribution, and unintentionally depletes their retirement savings.

Rule of 55 is totally not available to traditional or Roth IRAs.

Rule of 55 403 b

The Rule of 55 applies to 403b accounts. 403b account holders are allowed to take penalty-free distributions in the year they leave work, and as long as they turn 55 or older in the same year.

Please note that to qualify for penalty-free distributions, all funds must remain in the 403b plan.

Rule of 55 Roth IRA

Roth IRAs are funded by after-tax contributions, hence Roth contributions can be withdrawn at any time without taxes or penalties. However, taxes and penalties accrue on interest or investment gains;

• If withdrawals are made before the golden age of 59 1/2, or
• The account has been in existence for less than 5 years.

Rule of 55 is not applicable to Roth IRAs, should you lose your job at age 55 taxes and penalties accrue on your earnings, but not your contributions.

Does Rule of 55 apply to IRA      

IRS does not allow penalty-free withdrawals from any IRA including traditional, Roth, and rollover accounts. This has to wait until age 59½ or else the early access penalty applies.

The rule is not even applicable to 401k from the most recent employer that was rolled into an IRA. Fortunately, there’s a loophole around this, you could roll over the funds from previous employers’ 401k and IRA plans into current employers’ 401k.

Please note that this process is never that easy, and most employers do not accept rollovers.

Rule of 55 vs 72t

What is the 72t Rule

Generally, early access to pre-tax 401k or individual retirement accounts is frowned upon by IRS and will trigger a 10% early access penalty on top of levies. However, several exceptions are allowed, with Substantially Equal Periodic Payments (SEPPs) being one of them.

SEPPs are a series of distributions for five years or until age 59½, whichever is longer. They are also known as 72(t).

This series of distribution are calculated by estimating your life expectancy, Then used to calculate five similar size payments that will be paid five years in a row.

The major distinction between SEPPS and the rule of 55 is that these distributions are allowed at any age—55 years is not the threshold.

However, the rule of 55 is superior as it’s automatic and has no amount or timing requirements.

Rule of 55 Alternatives

These are circumstances from which the IRS may exempt the early withdrawal penalty. They include:

• Total and permanent disability
• Distributions made due to qualified disasters
• Certain distributions to qualified reservists on active duty
• Medical expenses that exceed 10 percent of the contributor’s adjusted gross income
• Withdrawals made to satisfy IRS obligation

Rule of 55 withdrawals

 Rule of 55 401k withdrawal

Below is a summary of conditions that must be met for the Rule of 55 to apply;

• Does the 401k plan allow it?

  Make sure the rules of the plan rules allow the rule of 55 withdrawals. Most sponsors ensure their plans prohibit withdrawals prior to age 59 ½ some even up to 62.

• Be 55 years or older.

  You should have left employment (voluntarily or involuntarily) in or after the year that you turn 55 years old.

• Assets must remain in the plan.

  These funds must remain in the sponsor’s plan before leaving employment and you can only be accessed via your current employer’s plan. Should you roll to an IRA, you lose the rule of 55 tax privilege.

• Public safety worker.

  Qualified public safety workers i.e. police officers, EMTs, firefighters, correctional officers or air traffic controllers, etc., are allowed to access their funds 5 years early on without penalties. This is as long as the qualified plan allows withdrawals in or after the year you hit 50.

Please keep the following in mind if you are about to access your assets via the rule of 55;

• Potential gains that will be lost.

  Early withdrawals are equal to forfeiting any tax-free gains that would have been earned if the funds stayed in the fund.

• Plan for the taxes.

If you have quit or lost your job, it might be a good idea to delay access to your funds until the next calendar as this avoids increasing your marginal taxes. This way, you will have less taxable income as the rule of 55 withdrawals will be only your taxable income.

Bottom Line

Access to quick cash and minimal penalties is very vital for retirees, especially if faced with early or unexpected retirement. Familiarizing yourself with the rules on access to your qualified plan at 55 or older can be a bonus to your finances.

Ensure all funds remain in the current 401K plan, Any funds rolled into an IRA lose the protection of the Rule of 55.

It’s a good idea to only access tax-deferred accounts during low-income calendar years. This could potentially save a lot in taxes, especially if they are indications that your marginal tax rate will be higher in the future.

Only the current employer’s plan qualify for the Rule of 55. Rollover as much money from previous employers into a current plan to provide yourself with some flexibility should the need arise.