How does the "Rule of 55" work for avoiding early 401k withdrawal penalties?

Question

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?

Answer 1

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.

Answer 2

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.

Answer 3

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.