Tax-advantaged retirement accounts are a common way to save and invest for the future. However, those valuable accounts—which may include 401(k)s, 403(b)s, and IRAs, among others—are governed by a few very important rules from the IRS. 

The IRS rules dictate how much investors can contribute to these accounts each year, when the funds are taxed, and when investors can begin to withdraw money. Those who retire early or need to access funds before retirement age (currently 59 ½) can often do so, but early distributions may result in penalties.

There are a handful of exceptions to these penalties, however. Depending on the situation and the type of account(s) they own, investors may be able to begin taking retirement distributions before age 59 ½ without a tax penalty, especially if they leave their job. One such exception is the rule of 55.

What is the rule of 55?

The rule of 55 is an IRS penalty exception that waives early withdrawal fees for account owners who need access to retirement income in the years immediately before retirement. It applies to both 401(k) and 403(b) accounts, but does not cover individual retirement accounts (IRAs).

The rule of 55 benefits workers who are laid off, fired, or quit their jobs between the ages of 55 and 59 ½, when typical distributions are allowed without penalty. As long as the separation of service occurs in the year the investor turns 55 (or later), the 10% early withdrawal penalty can be waived if they take distributions from an eligible retirement account.

The rule of 55 may be advantageous to younger workers, too. Qualified public safety workers employed by either the federal state or local government may invoke this rule as early as age 50, as long as the separation occurred in or after the year they turned 50.

Limitations to the rule of 55

The rule of 55 only applies to non-IRA qualified retirement plans. This means traditional IRA and Roth IRA funds are ineligible for the penalty waiver. The rule also doesn’t apply to retirement plans offered by past employers. Only funds held in a current employer’s retirement plan are eligible.

It’s important to note that while the rule of 55 can waive the penalty fees on qualified early distributions, any IRS tax burden on those distributions remains. Withdrawals from both traditional 401(k) and 403(b) accounts are subject to ordinary income taxes.

How to use the rule of 55 to retire early

Since the rule of 55 applies to a worker’s separation from an employer regardless of the reason, it can theoretically be used to retire early. However, this still requires some planning to be executed successfully. Every retiree’s needs will be a bit different, depending on existing assets, spending habits, and the age at which they plan to retire. Workers can consider what their unique retirement needs will be—and how long any existing retirement savings will last—when determining whether an early retirement is within reach.

Again, the rule of 55 only applies to retirement plans offered by a current employer; retirement savings held by former employers are not eligible for the penalty waiver. This can be solved by combining current and former retirement plan funds into the current account. A 401(k) rollover, for example, is a common consolidation method.

Even after a retiree withdraws funds using the rule of 55, they are not locked in to retirement. As long as withdrawals only come from that account, the early withdrawal penalty will continue to be waived, even if the early retiree returns to part- or full-time work.

SEPP programs

A potential alternative to the rule of 55 for early retirees may be substantially equal periodic payments, or SEPPs. SEPP programs also allow distributions from various qualified retirement plans—such as IRAs, 401(k)s, and 403(b)s—before the account owner reaches 59 ½.

With a SEPP plan, equal, scheduled distributions are taken from a retirement account for either five years or until the owner reaches 59 ½.

What does this mean, exactly? Well, if a retirement account is opened and funded closer to the typical retirement age, the account owner will need to wait at least five years before taking scheduled distributions, no matter their age. If someone were to open and fund a retirement account at age 57, they would need to wait until age 62 to begin taking distributions, even once they’ve met the 59 ½ age threshold. An SEPP program could allow them to shortcut this waiting period.

The early retiree will need to choose between three configurations for their SEPP plan:

• Amortization:

  This method involves equal annual withdrawals based on the life expectancy of the individual (and in some cases, their beneficiary) as well as an interest rate equal to no more than 120% of the federal mid-term rate.

• Required minimum distributions:

  This method takes the current account balance and divides it according to the individual’s life expectancy, to find an annual withdrawal amount that changes each year.

• Annuitization:

  With annuitization, the individual will receive an equal annual payment that is calculated using the account balance, provided IRS mortality tables (based on age and other factors), and a chosen interest rate.
  

This will help determine their withdrawal amount, which is determined by specific IRS formulas.

As with the rule of 55, early withdrawal penalties are waived with SEPP plans. However, if the SEPP plan is abandoned before age 59 ½ or year five (whichever is later), all deferred penalties must be repaid, with interest.

Unlike the rule of 55, SEPP plans allow early retirees to pull from IRAs (as well as 401(k)s and other qualified plans). Also unlike the rule of 55, withdrawals from a 401(k) retirement plan held by a current employer are not allowed. Instead, withdrawals must be taken from other types of retirement savings or from a previous employer’s 401(k).

The bottom line

There are many reasons a worker may need to access retirement funds before they reach age 59 ½, when the IRS begins allowing penalty-free withdrawals. Whether a worker is laid off, fired, or simply quits their job, the rule of 55 may make it possible to access certain savings in the years immediately preceding retirement.

With the rule of 55, there are some specific requirements and it does not apply to all different types of retirement plans. However, this penalty waiver may provide necessary access to penalty-free distributions for workers over the ages of 50 or 55.

Side note: Try Titan’s free Retirement Calculator to project how much you'll need in retirement.