Smart Money Tips

What’s the Early Retirement Provision in 401(k) Plans?

  • Did you know you can retire early at age 55?
  • A provision in the IRS Code allows workers to take money out of employer-sponsored retirement plans, such as a 401(k), before the usual retirement age of 59½. You must meet certain criteria, however.
  • This option might be appealing to people who want to get a jump start on their golden years without incurring early distribution penalties from pre-tax accounts.
  • Also, the strategy outlined below can help individuals who need to access their savings for other purposes, perhaps due to an unexpected job loss. 

Understanding the Early Retirement Provision in 401(k) Plans

It’s known as the rule of 55. It is an IRS provision whereby workers age 55 and older are allowed to take distributions from workplace plans without penalty after they have left their job. In essence, with the right planning, you are able to retire a few years early rather than waiting until age 59½ to take normal distributions as you would with other retirement accounts. Most importantly, the rule of 55 surrounds 401(k) and 403(b) plans, not your IRA. Also, not all companies offer this provision, so be sure to check your plan documents or with your HR department.

Knowing the Rules

There are three key provisions to meet in order to take advantage of the rule:

  1. You must separate from service at age 55 or later AND
  2. Take distributions from the most recent employer’s 401(k) plan AND
  3. The plan needs to allow for partial distributions after termination

Avoiding the 10% Early Distribution Penalty

The big benefit of the early retirement provision in 401(k) plans is that you can bypass the 10% early withdrawal penalty, but you are still on the hook for federal and state income tax. The IRS outlines, however, that you cannot separate from your job before age 55, and that previous 401(k)s and all IRAs are not included in the provision. Therefore, if you just recently began working for a company and are turning 55, it probably does not make sense to attempt the strategy. It can be a viable option, though, for folks who have a long tenure at a firm.

How It Might Work for You

For example, let’s say you worked at a company for 20 years and amassed a 401(k) account balance of $500,000. You also have savings in an IRA as well as in a taxable brokerage account. While Social Security is still many years away, you can call it quits in the year you turn 55, then withdraw from the 401(k) account and simply owe income taxes. You can think of it as a bridge to traditional retirement age. Once you reach age 59½, you might then distribute funds from other retirement accounts without penalty. The rule of 55 can also be a financial lifeline for people who are laid off late in their careers. Finally, if you just want to switch jobs, the same rule applies so long as you meet the requirements.

Tips to Maximizing the Rule of 55’s Value

If you are curious about leveraging this early retirement provision, you should not roll over your 401(k) to an IRA since that would disqualify you. Another risk to be aware of is that you are missing out on potential gains in the market by pulling money from the account. Finally, you might want to delay taking distributions until the calendar year after you stop working so that you minimize your federal taxes owed as you might have had high income from employment in the previous year.

There’s flexibility with the rule as you are allowed to get another job while still taking penalty-free withdrawals from the old 401(k) plan. Additionally, a planning strategy you should think about if you have your heart set on retiring at age 55 is to move IRA money into your current 401(k) plan while you are still employed so that you have a bigger 401(k) plan balance when you hit 55.

The Bottom Line

You should strive to never pull money from any of your retirement accounts during your working years. That sounds like a no-brainer, but tough times often happen. With a Roth IRA, it’s totally fine to take some cash from the account – you do not have to worry about owing a 10% early withdrawal penalty or facing an income tax bill on the distribution. Your contributions may be withdrawn at any time tax-free and penalty-free. You can use it almost like an emergency fund.