What Is the Rule of 55?

Understand the IRS Rule for Taking 401k Distributions Starting at Age 55

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If you have a 401(k) plan, you probably already know that there's usually a 10-percent penalty for withdrawing any of the funds before you reach age 59 1/2. But there are some exceptions to this early distribution rule and one of them affects pre-retirees in particular. It's known as the Internal Revenue Service's "Rule of 55." If you're age 55 or older, it's something you should know about. 

What Is the Rule of 55?

The IRS Rule of 55 allows an employee who is laid off, fired, or who quits a job between the ages of 55 and 59 1/2 to pull money out of his 401(k) or 403(b) plan without penalty. This applies to workers who leave their jobs anytime during or after the year of their 55th birthdays.

Of course, there's a catch. The Rule of 55 only applies to assets in your current 401(k) or 403(b)—the one you invested in while you were at the job you're now leaving at age 55 or older. If you have money in a former 401(k) or 403(b), it's not eligible for the early withdrawal penalty exemption. You would have to wait until age 59 1/2 to begin withdrawing funds from those accounts if you wanted to do so without paying the 10-percent penalty. 

This rule of 55 does not apply to individual retirement accounts, either. If you were to move assets into a rollover IRA upon leaving your job, you would not be eligible for early withdrawal under the Rule of 55. 

What Is a Section 72(t) Distribution? 

There's another way to take money out 401(k), 403(b), and even IRA retirement assets if you leave a job before the age of 59 1/2. It's known as the Substantially Equal Periodic Payment or SEPP exemption. It's an IRS Section 72(t) distribution.   

Using this type of distribution rule, you would start by calculating your life expectancy and use that to calculate five substantially equal payments from a retirement plan for five years in a row before the age of 59 1/2. But distributions can occur at any age and they're not bound by the same age 55 threshold as the Rule of 55. 

Should You Take Either Distribution? 

The ability to take money out early can be a great safety net for those who find that they must retire before age 59 1/2. But if it's possible to hold off and find another job, a part-time job, or to work as a consultant, it might make more sense to let the money continue to grow tax-deferred well into your sixties if possible.

Taking funds out early could decrease the long-term value of your portfolio. This is particularly true if your initial years of retirement are bad ones for the market. If you expect to live a long life, early distributions could put your future income at risk.

Consider the timing of all portfolio withdrawal decisions carefully. Work with a tax advisor, a financial planner, or your retirement plan administrator to create a sustainable withdrawal strategy. 

Note: Always consult with a tax professional for the most up-to-date information and trends. Tax laws and rules can change periodically. This article is not tax advice and it is not intended as tax advice.