IRS rules make it very easy to make tax-advantaged contributions to retirement accounts. However, getting your money back out before age 59.5 typically triggers taxes and penalties. Fortunately, if you are already age 55, there is a special rule that will allow you to access your funds penalty-free. The “Rule of 55” could save you serious money if you want to retire early or make a one-time withdrawal from your plan to cover a major expense.
It’s your Solo 401k money and you can use it at any time but if you withdraw it before age 55, but you will normally have a 10% penalty. There are some exceptions to this that are covered in this blog. The 10% penalty is in addition to the 401k withdrawal to your income for the year and paying income tax on the withdrawal. (A Roth 401k withdrawal before age 55 will be subject to the 10% penalty and taxes will be owed on the earnings but taxes will not be owed on the contribution portion that has already been taxed).
Fortunately, the Rule of 55 is another path to early retirement that is penalty-free before age 59 ½.
With rule 55, you will still owe income taxes on your withdrawals, but you won’t have to pay the 10% extra penalty.
What You Need to Know Before Retiring at Age 55
Your early retirement can begin as soon as age 55 if you meet two specific requirements:
- You are no longer employed by the company with whom the 401k is associated (includes your Solo 401k business).
- You left that employer during or after the calendar year in which you reached age 55.
“[this exception applies to distributions from a qualified retirement plan] Distributions made to you after you separated from service with your employer if the separation occurred in or after the year you reached age 55, or distributions made from a qualified governmental benefit plan, as defined in section 414(d) if you were a qualified public safety employee (federal state or local government) who separated from service in or after the year you reached age 50.”
How you separated from your previous employer does not matter. You might have been fired, quit, or been laid off. It doesn’t matter. The only employment requirement is that you are no longer employed by the business that previously sponsored the 401k plan. In the case of your Solo 401k, this likely means shutting down the business or turning it over to another person without you remaining employed by the business. You may also qualify if you left a 401k with another employer at or after the age of 55. For instance, if you terminated from Business XXX at age 56 and left a 401k behind, those funds can qualify under the age 55 rule. You don’t even have to be retired to withdraw those funds without paying the 10% penalty.
You must have been age 55 or older in the year your employment ended. It is not the date that you begin taking the early withdrawal. The age that counts is your age in the year of separation from your previous employer. Multiple scenarios can affect this. For instance, you may have retirement funds from a job you left before turning 55. If those funds remain with that early employer, the funds will not qualify for rule 55. However, you could consider rolling funds that you have in an old 401k into a Solo 401k. This may be a good choice if you plan to retire between the ages of 55 and 59 ½. Also, some companies don’t allow early withdrawals based on the rule of 55 – another reason to consider a Solo 401k. (Talk to your financial advisor before making this decision).
It’s possible to apply rule 55 to multiple 401k accounts. For whatever reason, you left company YYY after turning 55 and went to work for company ZZZ. And by age 57, you are no longer working for company ZZZ. Rule 55 can work to avoid paying the 10% penalty from the 401k plans administered by both company YYY and company ZZZ. On the other hand, you could continue working for company ZZZ while also using rule 55 to make withdrawals from company YYY.
There is an important caveat to rule 55. It does not apply to IRAs (aka individual retirement accounts or arrangements). If you move 40k funds from a previous employer into an IRA, you will not be able to make penalty-free withdrawals until age 59 ½.
Instead of rolling your employer 401k into an IRA, roll it into a Solo 401k before taking early retirement.
If you do decide to tap into your savings between 55 and 59 ½, make sure you’re following all the rules to avoid penalties. Something else to consider is the timing of your withdrawal. If you take it the same year you retire, it could increase your taxable income for that year and bump you into a higher tax bracket. Waiting until the next January after you exit the job could save money on your tax bill.
Other Alternatives to the Rule of 55
There is a way to avoid the 10% early withdrawal penalty even before reaching the age of 55. This is the Substantially Equal Periodic Payment (SEPP) exemption, under IRS Section 72(t). Of course, SEPP has a different set of rules.
Once you start taking SEPPs, you have to continue for 5 years or until you turn 59.5 – whichever is later. If you quit the SEPP plan before it ends you will have to pay all the penalties it usually allows you to avoid, plus interest on those amounts. Income tax will still be paid on withdrawals.
SEPP distributions can happen at any age — they do not have the same age requirements, like the Rule of 55.
There may be more options that you might not have thought of. Distributions made from a qualified governmental benefit plan, defined in IRS section 414(d). If you were a qualified public safety employee (for the federal state or local government) who separated from service in or after the year you reached age 50.
There are a few special circumstances when the 10% penalty does not apply under an IRS qualified financial hardship withdrawal. These include both traditional and Roth 40k1k accounts:
- Medical expenses that exceed 5% of AGI (includes employee, spouse, dependents, or beneficiary).
- Permanent disability.
- Directly related to the purchase of an employee’s principal residence (excluding mortgage payments).
- To prevent the eviction of the employee from the employee’s principal residence or foreclosure on the mortgage on that residence.
- Certain expenses to repair damage to the employee’s principal residence.
- Funeral expenses (employee, spouse, children, dependents, or beneficiary).
- Tuition, related educational fees, and room and board expenses for the next 12 months of postsecondary education (employee, spouse, children, dependents, or beneficiary).
- Up to $100,000 via the COVID-19 CARES Act through December of 2020.
Although a hardship withdrawal might be eligible to avoid the 10% penalty, it still incurs income taxes on the sum you withdraw. One big downside of hardship withdrawals is that you can’t repay the money back into your plan. A Solo 401k loan might be a better alternative.
Ultimately, the IRS doesn’t have much control over your retirement – you can have full control. There are ways to retire early without paying the 10% early withdrawal penalty.
Consult your financial advisor or estate planning professional.