How to Tap Your 401(k) at 55 Without a Penalty
At age 55, some people are still scrambling to fund their 401(k)s. But if you've been steadily making contributions and taking advantage of employer matching dollars since your 20s, you may reach your mid-50s with a pretty impressive pile of cash -- enough cash that you can conceivably decide ...
Overview
At age 55, some people are still scrambling to fund their 401(k)s. But if you've been steadily making contributions and taking advantage of employer matching dollars since your 20s, you may reach your mid-50s with a pretty impressive pile of cash -- enough cash that you can conceivably decide you're retiring early to start enjoying the good life. There's just one problem. Typically, withdrawing from a 401(k) before age 59 and 1/2 leaves you subject to a 10% penalty. But thanks to a lesser-known tax rule, you may be able to access funds from your 401(k) penalty-free sooner.
Read:How do I catch-up on my 401(k) savings?
How the Rule of 55 works
The Rule of 55 allows workers to take penalty-free withdrawals from a 401(k) or similar workplace retirement plan if they leave their job during or after the calendar year they turn 55. But the rule is pretty nuanced. And it's important to understand exactly how it works since it's your money on the line. The primary thing you need to know is that the Rule of 55 only applies to the retirement plan that's offered by the company you separate from at or after 55. It does not apply to previous retirement plans.
So let's say you're 55 and want to leave your employer at the end of the year. Let's assume you also have a $400,000 balance in that employer's 401(k). That $400,000 should be yours to access penalty-free once your employment comes to an end. But if the rest of your money is sitting in a rollover IRA worth $1.2 million, that $1.2 million is excluded from the Rule of 55. If you tap that IRA before turning 59 and 1/2, you risk the aforementioned 10% early withdrawal penalty.
Details
Similarly, if you leave your job and roll your $400,000 401(k) balance into an IRA, you could lose access to that money penalty-free.
You don't necessarily need to be retired use the Rule of 55
Another thing to know about the Rule of 55 is that you don't have to be retired to take advantage of penalty-free withdrawals. Let's say you work a stressful job, and by age 55, you've had it. You could leave that job, moonlight as a paid artist, walk dogs, or even get yourself another office job with a full-time salary, and none of that will change your access to your savings under the Rule of 55. As long as you limit withdrawals to the retirement account of the employer you leave at 55 or later, you're fine.
Related: FTC survey: Older Americans getting hammered by scams
There are still taxes to consider
One key thing to remember is that while the Rule of 55 gets you out of the 10% early withdrawal penalty, it does not exempt you from taxes on traditional retirement account withdrawals. If you take a penalty-free withdrawal from your 401(k) under the Rule of 55, it'll be taxed at whatever ordinary income rate you're subject to. This is not a function of being under age 59 and 1/2. Traditional retirement plan withdrawals are always subject to taxes. You'll be paying the IRS a portion whether you tap your savings at 55 versus 75 versus 95.
Should you exercise the Rule of 55?
Well, that depends on you. It can certainly be a powerful tool if you're in a position to retire early and your only holdup is not wanting to give up 10% of your withdrawals due to your age. On the other hand, tapping your savings at 55 could involve some tradeoffs. Every dollar you withdraw in the near term won't continue growing for future years.
It's important to be mindful of your health and family history when making decisions like this. If you have parents who are still thriving in their mid-80s and your health is excellent, you may have a longer life ahead of you. If you start withdrawing from your savings at 55, it could become harder to stretch your nest egg. But if you have a good reason to access your savings at 55, you should know that there may be a way around that dreaded early withdrawal penalty. So it pays to read up on the Rule of 55 so you're able to use it strategically if you end up in a situation where it applies to you.
This story written for TheStreet by Nifty 50+
Source
Originally published at www.thestreet.com.
