There are very few occasions that the IRS will allow you to access money from your retirement accounts before reaching their defined retirement age of 59.5 without being subject to the 10% early withdrawal penalty. From a behavioral standpoint, this is a good “nudge” that keeps us from raiding our retirement accounts when unexpected expenses arise.
One of the occasions that the IRS will allow you to access funds early is through the ‘Rule of 55’. As the name suggests, this rule allows individuals to access funds from their 401(k) if they separate from their employer the year they turn 55 or later without being subjected to the 10% early withdrawal penalty.
If you think that you may qualify for the ‘Rule of 55’ now or in the future and want to plan around it there are a few things you will want to be aware of:
- In order to qualify, you must separate from your employer the year you turn 55 or later. If you turn 55 on January 1, 2023 but you separate from service on December 31, 2022 you will not qualify. Conversely, if you turn 55 on December 31, 2023 but separate from service on January 1, 2023 you will qualify for the rule.
- The funds must come out of the 401(k) offered by the employer you separated from employment with. This means that if you have multiple 401(k)’s from various employers or IRA accounts, those will not qualify for the ‘Rule of 55’ exemption.
- The funds can be taken at any time that the plan allows. Once a plan qualifies for the ‘Rule of 55 exemption, you can take funds from the account at any point between age 55 and 59.5.
If you are considering early retirement and will qualify for the ‘Rule of 55’ exemption, there are a few planning strategies that you can employ to ensure you have sufficient funds to cover the gap between retirement and when your remaining retirement funds are available penalty free at age 59.5. If your 401(k) plan does not have sufficient funds to cover the gap, you can complete a ‘roll-in’ of funds from an outside 401(k) or IRA to close the gap and those funds will be eligible with the rest of the account for the exemption. If you are going to pursue this strategy, there are two critical elements you will need to confirm with your plan provider:
1. That your plan allows for ‘roll-ins’ of outside retirement accounts. Each plan is different and some will allow for roll-ins of any outside retirement account, some will allow for certain roll-ins, and others won’t allow for any at all.
2. You will want to confirm the withdrawal options available within your plan upon separation from service. Some plans will allow withdrawals any time or through recurring systematic withdrawal plans. Other plans may only allow for a ‘full payout’ distribution which may negate many of the benefits that the exemption provides.
While the ‘Rule of 55’ exemption can provide great tax benefits, proper planning must be completed to ensure that you don’t succumb to any potential pitfalls and that you are able to optimize for the tax benefits that may be available to you.
If you’d like to discuss any of this strategy and how it might apply to your situation, schedule a meeting with our team here.
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