Retiring Early? Here’s how to access your retirement plan savings without penalty prior to age 59 ?. (Part One: the Rule of 55)
So you’ve had a successful career, saved up in your workplace retirement plan, and are ready to retire in your 50s (or even earlier!).
In this two-part series, we look at two options to begin to take early withdrawals from your plan, with the goal of minimizing taxes and avoiding any early withdrawal penalty. ?
If you've ever invested in a 401(k), 403(b), or similar tax-deferred plan, you likely know these plans are designed for participants to keep the money in the account and not tap it until at least age 59 ?. And we know that any distributions you take from these plans (that were funded with pre-tax money) will be fully taxable in the year that you withdraw the funds.
But did you know that withdrawals you take prior to age 59 ? are subject to an additional 10% penalty!
10% isn’t that much, right?!?
Well, using a hypothetical example (please see chart below), let’s say you just retired with $1,000,000 in your 401(k) and you are realistically projecting an average annual return of 5%. You began taking withdrawals on January 1st of this year at age 55 to cover your living expenses ($60,000 per year) and your taxes (22% federal tax rate). And the 10% penalty. Don’t forget an annual increase of 3% on your expenses to cover inflation.
On the surface, over the next 5 years, you will have lost $38,863. But as we know with all finance-related questions, you need to factor in the compound effect and the lost opportunity for that money to earn. This results in over $73k after 15 years.
Just because you didn’t follow the IRS Rule of 55.
There are, however, two ways to avoid this unnecessary penalty if you want access to your money a little earlier. These two ways have made for a nice topic for me to write about – and in a two-part series, nonetheless!
Please note: With these types of strategies, I cannot stress the importance of getting this right from the start – and wholeheartedly recommend consulting someone who has experience in this arena. To do this the most cost-efficient and effective way, you should begin to plan in advance so you will not be scrambling around after you retire trying to figure out where and how to get to your retirement funds. The last thing you want to do is create a tax headache for yourself, or worse yet, a tax AND penalty headache. (We’re talking about setting yourself up for the rest of your life here!!)
OK, so back to how to avoid the penalty and access your retirement funds prior to age 59 ?. Here is the first way, the Rule of 55.
What is the Rule of 55?
The IRS recognizes you might leave or lose your job before you reach age 59?. If that happens, you might need to begin taking distributions from your 401(k).
If you turn 55 during the calendar year you lose or leave your job, the IRS permits you to begin taking distributions from your 401(k) without paying the early withdrawal penalty, under the Rule of 55.
This withdrawal strategy not only works with a 401(k), but it also applies to 403(a) and 403(b) plans. If you have a qualified plan, you might be able to take advantage of this rule. You can verify the status of your plan by reviewing your former company’s Summary Plan Description for your workplace retirement plan.
Double-check to ensure your plan meets the requirements and consider consulting a professional before withdrawing money.
What specifics do I need to know about the Rule of 55?
Before you start withdrawing money from your 401(k), it's important to understand some specifics about the IRS Rule of 55.
You must leave your job the calendar year you turn 55 or later.
Yes, you must leave your job the calendar year you turn 55 or later (stated again for emphasis). The Rule of 55 does not apply if you left your job at, say, age 52. It does, however, apply if you’re older than 55 and leave your job. (So this age is reduced to 50 if you’re a public service employee).
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You can withdraw only from the plan specific to the employer.
Before you start taking distributions from multiple retirement plans, it's important to note the 401(k) withdrawal rules for those 55 and older apply only to your employer at the time you leave your job.
In other words, you can only take those penalty-free early 401(k) withdrawals from the plan you were contributing to at the time you left your job.
The money in other retirement plans must remain in place until you reach age 59 ? if you want to avoid the penalty. (Yes, there is a way around this, if you want to access to those additional retirement funds – this is where the “plan in advance” part of it comes into play with a transfer of those additional retirement funds into your current 401(k) or 403(b) plan before you retire.)
The balance must stay in the employer's 401(k) while you're taking early withdrawals.
The Rule of 55 does NOT apply to individual retirement accounts (IRAs).
If you leave your job for any reason and you want access to the 401(k) withdrawal rules for age 55, you need to leave your money in the employer's plan—at least until you turn 59 ?. You can take withdrawals from the designated 401(k), but once you roll that money into an IRA, you can no longer avoid the penalty. And if you've been contributing to an IRA as well as your 401(k), you can't take penalty-free distributions from your IRA without meeting certain requirements (so this is what’s called the “set-up” for part 2.….).
Should you use the Rule of 55?
Even if you're eligible to withdraw money penalty-free from your 401(k) or other qualified retirement plan early, consider it carefully. As with many things in life, just because you can doesn't mean you should. (Remember the example above of the compounding effect?) If you retire early, or if you were laid off and you need the distributions to cover living expenses, it could make sense. But if you get another job and are quickly back in the work force, it might make sense to hold off.
Finally, if you made Roth contributions to your 401(k), these withdrawals are usually tax-free, so determine if taking withdrawals from your Roth account in the 401(k) plan makes sense or if you should withdraw from the taxable account. Review your choices carefully and consider consulting with a professional to determine what will work best for your situation.
How else can I avoid the early-withdrawal penalty?
The following qualify under the IRS rules as exceptions to the early distribution tax:
(For more details, please go to: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-exceptions-to-tax-on-early-distributions#:~:text=Generally%2C%20the%20amounts%20an%20individual,tax%20unless%20an%20exception%20applies.)
And yes, there is another way to avoid the 10% early withdrawal penalty, which would be much more readily-available than these exceptions listed above. This will be discussed in part 2…..
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Bill Davis is a CERTIFIED FINANCIAL PLANNER? and Managing Partner with Vericrest Private Wealth LLC, a financial advisory firm in Newtown, Pennsylvania.
Vericrest Private Wealth LLC ("Vericrest") is an SEC registered investment advisory firm.??The information provided herein should not be?construed as personalized investment advice and should not be considered as a solicitation to buy or sell any security or investment advisory service.?Past performance is no guarantee of future results, and there is no guarantee that future investments will be profitable.? ?While we believe that third party information provided is accurate, Vericrest does not guarantee or otherwise warrant such information. ?For more information please contact Vericrest or refer to the Investment Adviser Public Disclosure website?(www.adviserinfo.sec.gov) to review important disclosures about our firm. ?