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How does the "Rule of 55" work for avoiding early withdrawal penalties from a 401k? What are the conditions around using the "Rule of 55"? Is it practical to use this rule?

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    In your example the numbers don't add up. The $100k has $20k federal withheld plus state tax. Even if you redeposit the full $80k to an IRA, there's tax due on the $20k withheld. Where is the money for the expenses you reference? By the way, we've referred to the age 55 exception many times here. Although I don't think we've called it "the rule of". – JTP - Apologise to Monica Aug 13 '15 at 1:03
  • I did a search for it and nothing came up. – Dynas Aug 13 '15 at 12:35
  • As I remarked, it was discussed in context, The most recent time I recall was a few weeks back at Want to retire at 55, but 401k starts paying at 59.5 years old – JTP - Apologise to Monica Aug 13 '15 at 13:10
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    And this - Welcome to Money.SE. We highly recommend that new members take the tour and spend some time reading top rated questions to get an idea of the nature of the board. You can find questions by tag or searching, to read up on what's been answered already. As Ben stated, a self-answered Q&A is acceptable, but not always easy to pull off. – JTP - Apologise to Monica Aug 13 '15 at 13:24
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It's a rare question where as a group, I don't see 'closure', i.e. an IRS or authoritative citation regarding the topic discussed. In this case, OP wrote:

This is ideal if your 401k plan allows for partial withdraws. Sometimes you will only have a Full Payout (aka Lump Sum) in which case you can split part of it off and avoid the penalty and then roll the rest into the IRA.

I don't claim to have seen every variation of what's allowed vs what's mandatory when it comes to 401(k) distributions. But if the quote about is true, it raises the need for a large asterisk on every time one references the rule. In OP's example, $100K is discussed. But if we are talking about a 55 year old who purposely rolled over prior accounts to this final 401(k), the number had better be far higher. So let's go with $1M, and the desire to withdraw $40K/yr staying with the 4% withdrawal rate generally accepted. (If not, that's another story).

Retiree, forced to take all or none, pulls out the $1M, and has a federal mandatory $200K withholding. Unless he happens to have an extra $160K available to pair up with his $800K rollover to an IRA, it's game over. The $200K is taxed at well over $40K $46,075+33% of the amount over $189,300 when his desired $40K withdrawal would barely have a $4000 tax bill. In effect, the rate he's propelled into negates any benefit of the lack of penalty this one year.

As Ronald Reagan said, "Trust, but verify."

If the post 55 partial withdrawals option is permitted, but not required, of the ex-employer, I'd like to see an authoritative citation. Obviously, this doesn't answer the original question above, but it does make the use of the strategy come under more scrutiny if this aspect is true.

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The 55 rule exempts the %10 penalty for withdrawal before 59 1/2. If you are 55 or older the year you leave 401k holding employer.

It does not force any specific withdrawal schedule on 401k or employer, so they can offer one time lump without 10% penalty or equal distribution over 5 years or til 59 1/2 whichever is LONGEST...without the 10% penalty for early withdrawal.

So it does not affect the purpose of the 55 rule which is avoiding the 10% penalty exception.

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The "rule of 55" only applies to what the IRS calls "qualified plans" like your 401k. The rule means you can avoid the 10% early withdrawal penalty on distributions from your 401k (not IRA) if you are 55 or older and separate from service AFTER turning 55 (meaning you quit/lose your job with that employer).

IMPORTANT: If you roll your funds over into an IRA after 55 the effective penalty free withdraw age sets to 59.5 as per the rules of IRAs.(see below)

The "Rule of 55" does NOT apply to IRAs though. So if you retire at 55 and leave your money in your 401k, you can withdraw however much you need and avoid the 10% early withdrawal penalty (assuming the plan allows partial withdraws). Any withdrawal is still considered taxable income to you.

If instead you retire and then roll your 401k to an IRA, the rule of 55 exception no longer applies. Once the money is in an IRA, you have to wait until age 59.5 to avoid the 10% early withdrawal penalty. So definitely consider your income needs between (age 55) and age 59 1/2 before you think about rolling your 401k to an IRA.

This is ideal if your 401k plan allows for partial withdraws. Sometimes you will only have a Full Payout (aka Lump Sum) in which case you can split part of it off and avoid the penalty and then roll the rest into the IRA.

This is a very rare situation but it does come up and lots of advisers either don't know about it or wont mention it.

EXAMPLE: You have 100k in 401k, your laid off at age 57; Plan allows for LUMP SUM W/D only. You need some cash to cover expenses for 3 months while you look for a job.

You have to take all 100k out at once, however you can split it up. So you can take say 20k to cover your expenses and pay taxes (BUT NOT THE PENALTY) since its Rule of 55 and then take the remaining 80k and roll it into an IRA.

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  • I've never heard of an employer being able to force a $100K lump sum. $5K or less, they can ask you to transfer your account, but not this large. Can you back this up with a citation? – JTP - Apologise to Monica Aug 13 '15 at 17:51
  • Not force. But once you terminate employment with the company they often will have only a LUMP SUM option. You can leave the money in the 401k as long as you want up until 70.5, so nothings stopping you from doing that. But there are plenty of plans that require an All or None sort of payout, especially when you terminate employment. – Dynas Aug 13 '15 at 18:27
  • The 5k or less...Maybe your referring to a deminimus distributions. Generally if you leave employment and are under 10k and they will either do an automatic rollover to an IRA or sometimes mail a check (non taxable) with a designated time frame for the individual to deposit it into an IRA to avoid taxes. This is not what I'm referring to with the rule/exception of 55. – Dynas Aug 13 '15 at 18:29
  • "once you terminate employment with the company they often will have only a LUMP SUM option" - this is what I've never seen, and it would, defacto, destroy the 55 rule benefit. A 55 year old should be able to take 4.5 years of measured distributions. Again, the lump sum doesn't seem right. – JTP - Apologise to Monica Aug 13 '15 at 18:44
  • It is. I have seen it on dozens of 401k plans. It does suck for the person though because they only get a one time rule of 55 withdraw rather than numerous payments (hence the explanation above). It all depends on the plan. If it is a good plan you will see a partial w/d upon termination but a lot of times this doesn't happen until they are 59.5. Often the plan will only have the Full Payout/Lump Sum option where they have to take all the money out. This can be either a taxable event or a rollover. – Dynas Aug 13 '15 at 18:48

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