The Rule of 55

Did you know there is an IRS regulation designed to help people retire early? Not only that, but it can also help with unexpected changes that may happen late in a person's career, but before retirement benefits kick in. It's called "The Rule of 55," and it can make a big difference when it comes to planning for retirement.

What is The Rule of 55?

"The Rule of 55" is the nickname given to an IRS regulation which allows people aged 55 and older to withdraw funds from an employer-sponsored, tax-deferred retirement plan such as a 401(k) or 403(b) without being subject to early withdrawal penalties. While these withdrawals are still subject to income tax as usual, they would normally also incur a 10% tax penalty for funds withdrawn from a retirement account before reaching age 59 ½. This creates a unique opportunity for people who want to retire early, or a safety net for those facing an unexpected need for liquidity.

When Does The Rule of 55 Apply?

The rule of 55 applies when an employee is laid off, fired, or quits a job between the ages of 55 and 59 ½. In this scenario, funds may be withdrawn from a 401(k) or 403(b) sponsored by that particular employer. Funds in previous retirement accounts, such as those from an earlier employer or an IRA, are subject to a 10% early withdrawal penalty. An employee must leave their job in the calendar year they turn 55 or older (or in some cases for public service employees with a 403(b), the calendar year they turn 50). Anyone who leaves their job is eligible for the rule of 55, regardless of the terms of their separation.

Strategies to Consider

Only a person's most recent employer sponsored retirement account is eligible for these withdrawals. However, if an employee knows they will be leaving their job, they can rollover assets from previous retirement accounts to their current employer prior to their departure, making these funds eligible for penalty-free withdrawals. The rule of 55 is flexible as well. A person can return to work after beginning their withdrawals, as long as they only make withdrawals from the original eligible account.

It's not always the best decision though to remove money from a retirement account, even if the account is eligible under these rules. If the money isn't needed for immediate expenses, it might make more sense to let the investments continue to grow, tax deferred. Removing funds early can reduce the long-term value of your investments.

Not all retirement plans support these withdrawals. Some may require the withdrawal to be made in a single lump sum, which can come with unwanted tax consequences. There is wide variance between plans, so be sure to check with the plan provider for specifics.

There are a few instances that allow a person to avoid the early withdrawal penalty before the rule of 55 would apply. This includes total and permanent disability, qualified disaster distributions, if the funds are used to pay for deducted medical expenses that exceed 7.5% of a person's AGI, and more.

As with all things IRS related, it's important to follow the rules as closely as possible. Missteps can lead to withdrawals no longer being eligible, therefore subjecting them to the 10% tax penalty. A financial expert can help navigate this process.

The information provided is for informational purposes only. It is not intended to be used, and should not be used, as the sole basis for legal and/or tax advice. Individuals should seek and rely upon the guidance and advice of their own legal and tax counsel before making any decisions regarding any planning, investment, tax concepts or strategies discussed herein. Individual circumstances may vary and results discussed are no guarantees of applicability or future performance.

Certain of our representatives are Certified Public Accountants with the accounting firm Bowen-Crowe Group, LLC which is affiliated with Marietta Wealth Management. To the extent that these representatives provide accounting services, which may include tax advice, to any clients, including our advisory clients, all such services shall be performed by those representatives, in their individual professional capacities, independent of our advisory firm, for which services we shall not receive any portion of the fees charged by the representative, referral or otherwise. It is expected that these representatives, solely incidental to their practices as accountants, recommend our advisory services to certain of their clients. No client of Marietta Wealth Management is under any obligation to use the accounting services of these representatives. Our Chief Compliance Officer remains available to address any questions that a client or prospective client may have regarding this potential conflict of interest.